This is another interest question recently read from a book:
Imagine that you face the following pair of concurrent decisions. First examine both decisions, then make your choices.
Decision (i): Choose between
A) Sure gain of $240
B) 25% chance to gain $1,000 and 75% chance to gain nothing
Decision (ii): Choose between
C) sure loss of $750
D) 75% chance to lose $1,000 and 25% chance to lose nothing
What’s your decision?
(Write it down and we will compare afterwards)
Most of the people from the experiment chose to pick a A) sure gain of $240 in Decision (I) and choose to take a chance in Decision (II) by picking D) 75% chance to lose $1,000 and 25% chance to lose nothing. That is inline with the behavior finance understanding: when it comes to gains, people is more inclined to go for a sure win, however when people are facing a decision between sure-loss or lose nothing, especially the chance of a sure-loss is high, people intend to gamble and take a chance.
Approximately over 90% of the participants picked A) and D).
However, have you considered the combination of B) and C), especially you were asked to consider these two decisions together?
If you pick A) and D), your overall expected value is 75% chance losing $760, 25% chance gaining $240
If you pick B) and C), you have 75% chance losing $750, 25% chance gaining $250
Which combination gives you best expected value?
This is the power of portfolio thinking and risk diversification. Also, it shows that many of us still easily to use their intuition to look at a decision one by one, not realizing that they will have a better outcome if they slow down and evaluate two situations (or more situations) on a holistic manner.
Especially for portfolio managers out there, make a note of such potential decision-making weakness to maximize values and minimize risks.