By Daniel Archibald | CFA
Despite what we may think of ourselves, most people are not necessarily rational when it comes to decision-making. This is particularly true of investors, which can help to explain why prices of assets may drift far away from any fundamental level of value. One example of this is the question of why do people buy both insurance and lottery tickets.
On the surface, the outcomes of both these items may seem the same. You pay a small amount each week/month (insurance premium or lottery ticket price) and you receive a large payout (insurance benefit or lottery winning) should a low probability event occur. However, despite this similarity, the two scenarios are actually near opposite ends of the risk spectrum.
With insurance, the objective is to protect an existing asset. Effectively, insurance is helping to reduce the risk of the asset or reduce the volatility of the potential outcomes for the asset. The insured is happy to lower the potential gain of the asset (by the cost of the premiums) in exchange for eliminating the chance of a catastrophic loss. This is the behaviour of a risk-averse individual.
With lottery tickets, there are no assets backing the outcome. The lottery participant is happy to incur known losses for the chance of striking it rich. This effectively increases the volatility of the potential outcomes for the individual. This is the behaviour of a risk-seeking individual.
But, if someone buys both insurance and lottery tickets, can they be both risk-averse and risk-seeking?
The solution to this paradox most likely lies in the way most of us perceive outcomes and the manner in which we behave towards gains or losses. As shown in the seminal work of Kahneman and Tversky ("Prospect Theory", 1979), most individuals are risk-averse when it comes to gains and risk-seeking when it comes to losses. The expected outcome when we buy insurance is a reduced gain (hence risk-aversion), whereas the expected outcome when we buy lottery tickets is a loss (hence risk-seeking).
This theory also helps to explain why investors sometimes make seemingly irrational decisions. For example, most investors tend to hold reference points or price levels when it comes to investments they have bought. From this reference point, it easy for the investor to then calculate whether the investment is at a loss or a gain. However, because of the split-personality of most investors, many will tend to delay selling a loss-making asset (risk-seeking - happy to continue to lose more for the chance to make losses back) and will be quicker to sell a gain-making asset (risk-aversion - happy to forego more gains to ensure gains already made are not lost). However, rational decision-making should really only take into account expected future risks and returns, and the investor's risk tolerance.
There are many other behavioural quirks to which investors are inclined. A good understanding of these can help to prevent poor decision-making and increase overall performance of portfolios.