Be Risk-Averse, Not Loss-Averse in Stock Markets, And In Life Too
“The quantity of a man’s pleasure from a ten dollar gain does not exactly match the quantity of his displeasure from a ten dollar loss." — Charlie Munger
Here's a riddle for you. Option A has an 85% chance of winning $100 and Option B has a sure gain of $85. Which one do you choose?
It is quite probable that you chose Option B, presumably because you thought of yourself as a conservative person. A bird in hand is worth two in the bush, right? Maybe not.
Let's try a similar riddle, with changed words.
Option A has an 85% chance of losing $100 and Option B has a sure loss of $85. No matter what you do, you gotta bear one of these losses. Which one will you choose?
It is quite probable that you chose Option B, presumably because you thought of yourself as a conservative person. A bird in hand is worth two in the bush, right? Maybe not.
It is quite probable that you chose Option B. That's the behaviour of a gambler! Reminds me of the Hollywood classic 21.
Anyway, these two riddles show you the power of words. Just by changing a few words, without changing the problem, our psyches turn from being conservative people to gamblers! And that, is what you call Loss Aversion.
The reason you like the idea of gaining $85 and dislike the idea of losing $85 is not that these amounts change your wealth. You just like winning and dislike losing - you dislike losing more than you like winning.
Loss Aversion, paradoxically, makes you a Risk-Seeker.
Loss Aversion also explains the behaviour of gamblers (and day traders) who become risk-seekers immediately after experiencing a string of losses. They will do almost anythingjust to “get back in the game".
Indeed, this inability of most human beings to treat losses and gains equivalently explains many things about human nature. The rational person, on the other hand, treats losses and gains equivalently. For them, the quantity of pleasure from a ten dollar gain is no different from the quantity of misery from a ten dollar loss.
Conclusion
Be risk averse, but not loss averse. You can accept investments where you might lose some money, but but the potential gains would cover the potential losses.
As investors, we must seek businesses which are risk-averse, but not loss-averse. You should avoid businesses who don’t want to diversify into allied and related sectors, because they are petrified of losses, should such experiments fail.
X by Alphabet Inc (Formerly Google) is a notable example of this kind of growth-mindset behaviour.
At X, we pride ourselves on moonshot thinking. Moonshots live in the gray area between audacious technology and pure science fiction. Instead of a mere 10% gain, a moonshot aims for a 10x improvement over what currently exists. The combination of a huge problem, a radical solution to that problem, and the breakthrough technology that just might make that solution possible, is the essence of a moonshot.
Let's try to inculcate this kind of radical thinking patterns into ourselves, so that we may create things that make the world a better place for all us.