Wednesday, February 10, 2010

When You Put it Like That . . .

Imagine that I give you two options:

Option A: You get $3000 with 100% probability
Option B: You get $4000 with 80% probability, and you get nothing with 20% probability.

Which one do you choose? Remember it.

Now forget about the first game. Let's start over. Imagine I give you the following options:

Option C: You lose $3000 with 100% probability
Option D: You lose $4000 with 80% probability, and you lose nothing with 20% probability.

If you're like most people, you chose Option A (about 80% choose A), and you chose Option D (about 92% choose D).

And if you're like most people, you're irrational - and that's okay.

These two problems are perfect mirror images of each other. If you choose Option B repeatedly, you will gain $3200 on average, which is larger than the certain $3000 that you get from choosing option A. That is, you win $200 more on average by choosing A.

The mirror: If you choose Option D repeatedly, you will lose $3200 on average, compared to a certain loss of $3000 of you choose Option C. That is, you lose $200 more on average by choosing D.

A perfectly rational person would always choose the equivalent choices A and C, or the equivalent choices B and D. To a rational person, A vs. B and C vs. D look exactly the same (and they are the same . . . even though you may still want to tell me that they aren't).

You should like winning money as much as you like keeping money. But you don't. You like keeping money more. In fact, you like keeping money so much that you're willing to take a worse average return -$3200 vs -$3000 in order to prevent yourself from losing money some of the time.

These two sets of options are an example of a psychological trick called framing. When problems are framed as losses, we act differently than we do when they are framed as gains - even if the problem is exactly the same from a rational view.

Framing enters into our lives every day. Friends frame problems to get you to agree. Salespeople frame problems to get you to buy. Politicians frame problems to get you to vote.

If you didn't know about it before, you do now. Watch out for framing tricks. It might help you to act in your own best interests.

Note: this problem is adapted from econoport.