Stock market and The Fourfold Pattern
For about a month now, I have been reading ‘Thinking Fast and Slow’, the international bestseller by 2002 Nobel laureate Daniel Kahneman. As most of you would already know, the book is about how our brain thinks, both emotionally and logically, and that we are not the paragons of reason we believe ourselves to be. From the effects of priming and biases to the famed WYSIATI (What You See Is All There Is), it shows how our brain takes shortcuts towards whatever seems cognitively easy.
There is a specific chapter dedicated to Fourfold Pattern which I found particularly interesting. It sits at the intersection of probability of happening of an event and how we respond if that event is a loss or a gain. Let’s take the below illustration (from the book) to understand this:
The certainty effect means that we would be inclined to choose lower benefit just to avoid uncertainty. Case in point, a choice between sure gain of $30 vs 80% chance to win $45 & 20% chance to win nothing. Here, the expected value of second option is $36 (45*80%+0*20%) but still a majority (including me) would prefer first option.
Possibility effect on the other hand means for highly unlikely events, we tend to assign more weights than they deserve. Consider this, you live in a city among 8 million people and someone tells you that there is a serial killer on the loose in the city. Technically, the chances of your encounter with ‘Jack the ripper’ here are 1/about 8 million or 0.0000125%. Pretty negligible right? Your thought process here would never go towards rationality. Rather, you would be inclined to think, ‘what if I am that one person?’ and thus you would be more wary of every person. The culprit is your vivid imagination or rarity of events.
Now let’s talk about the four quadrants.
The top left quadrant is where there is a high probability of a large win and due to fear of disappointment, we become risk averse and willing to accept unfavorable settlement. Imagine yourself in the shoes of a plaintiff. Your lawyer tells you that you have a solid case and there is a 95% chance you will win. But he also tells you that a legal case may be swayed in any direction. If you get an offer to settle for $9,000 (as against the expected value of winning $10,000*95%+$0*5%=$9500) you will be willing to accept it. The thought of not winning anything even after having a strong case will trump the logic of potential loss of $500. This goes to say we prefer certainty over higher rewards.
The lower left quadrant is why people, in hopes of large gain, are willing to pay for lottery tickets even though their chances of winning the same are very low (in a usual 6/49 lottery, the odds are about 1 in 14 million)
The lower right quadrant is where insurance is sold to people playing on their aversion towards losing a large sum even if the chances of happening of the same are very low.
And lastly, the upper right quadrant. This is something which impacts new traders in stock markets greatly. Assume you entered the market basis a trading strategy and it failed, accumulating an unrealized loss of $10,000 in your portfolio. Logically, your thought process should be to sell the shares and limit your losses to $10,000. But because of your tingling spider senses and a sliver of hope that the stock might rise in future and you might be able to at least recover your costs, you keep holding to it. This, more often than not, results in higher losses for novice traders and makes them averse towards future trades or market as a whole.
All of this goes on to say that how important a decision is for us or how we are impacted by it depends on more that just how likely it is to be. Choices between gambles and sure things are resolved differently, depending on whether the outcomes are good or bad.
Until next time, CHEERS!
