How can you remedy the exaggerated caution evoked by loss aversion and the exaggerated optimism of the planning fallacy? – Chapter 31

What are risk policies? – Chapter 31

The emotional evaluation of ‘sure loss’ and ‘sure gain’ is an automatic response of System 1, which takes place before the computation of the expected values of the gambles. People that have to make choices that involve high or moderate probabilities tend to be risk seeking when it comes to losses and risk averse when it comes to gains, which can be costly. These tendencies make you willing to pay a high price to receive a sure gain rather than face a gamble, and willing to pay a high price to avoid a sure loss.

Construing decisions is possible in two ways:

  • Broad framing: a single comprehensive decision, with four options.

  • Narrow framing: a sequence of two simple decisions, considered apart from each other.

The concept of logical consistency cannot be achieved be our mind. We tend to avoid mental effort and are susceptible to WYSITA, so we have the tendency of making decisions as problems arise, even when they have to be considered jointly. Broad framing blunts the emotional response to losses and increases the willingness to take risks. Financial traders shield themselves from the pain of losses by this type of framing. The combination of narrow framing and loss aversion must be avoided. Individual investors avoid it by checking less often how their investments are doing. Constantly checking is unwise, because the pain of frequent small losses trumps the joy of small gains. Deliberately avoiding being exposed to short-term outcomes improves the quality of decisions and outcomes. The short-term reaction to bad news is usually increased loss aversion.

A decision maker who is prone to narrow framing should have a ‘risk policy’ that he applies whenever a relevant problem arises. Examples of risk policies are: “never buy extended warranties” and “always take the highest possible deductible when purchasing insurance". A risk policy is a broad frame that embeds a certain risky choice in a set of similar choices. The risk policy and the outside view are remedies against two opposite biases that influence a lot of decisions: the exaggerated caution evoked by loss aversion and the exaggerated optimism of the planning fallacy.

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