Decisions, Decisions

CHW LogoI consider myself somewhat  risk averse.  For example, my brother-in-law is an entrepreneur who is borrowing and putting a good bit of his savings to start a new craft brewery; as much fun as that sounds, I don’t have the stomach for that kind of gamble, and I suspect the majority of people don’t (that’s why most of us are not entrepreneurs).  On the other hand, lots of people buy lottery tickets, which also seems like a pretty risky gamble.  So what’s the difference?

The answer may lie in prospect theory, as explained in a recent JAMA article.  Building on work by behavioral economists Daniel Kahneman and Amos Tversky (and laid out in more detail in Kahneman’s book Thinking, Fast and Slow), prospect theory is a framework for understanding choice.  There are several basic tenets.  First is that people tend to simplify complex choices by focusing on key differences, while ignoring similarities.  For example, when deciding on a vacation destination, if choice A will cost $2000 and require 8 hours of travel, while choice B costs $5000 but only 7 hours of travel, the difference in travel time will likely not even be considered in the decision, which then becomes simpler.  Second, choices are made with regard to a reference point, not on the absolute value.  Two candidates for a position will see a salary offer of $50,000 very differently if one is currently making $40,000 and the other is making $60,000.  This may seem obvious.  In health care, treatment outcomes are going to be weighed against that reference point, which may be a patient’s current state of health, or a remembered past state of health.  Difference in reference points explain some of the difference in risk tolerance between individuals.  A corollary to the concept of the reference point, one that is backed by a good deal of experimental evidence, is that people tend to prioritize preventing a loss over achieving an equal gain.  This is called the endowment effect – we feel the loss of something we already have more than the regret at not getting something we only hoped for.   In one interesting experiment, people were offered the chance to buy a mug a coffee mug, or given the mug and then given the chance to sell it.  People were willing to pay on average about half as much to acquire mug they didn’t have, compared with what they would accept to part with the one they had gotten for free.  It appears that a bird in the hand is quite literally worth two in the bush.

The third element of prospect theory is that, after simplifying and framing the choice, people consider the desirability and probability of each outcome and estimate the expected value of each choice.  However, there are many cognitive inconsistencies and biases that creep in.  For example, we tend to place more weight on proportional than absolute differences.  A difference between winning  $1 and $3 is not treated the same as the difference between $98 and $100, even though each results in someone being able to buy one additional cup of coffee the next day.   Conversely, very small probabilities are difficult to deal with intuitively.  We tend to either ignore them completely (as in, my chance of winning the lottery went up 10-fold, from 1 in 10,000,000 to 1,000,000 – it’s still nearly impossible so I’m still not buying a ticket) or blow them out of proportion (as in, Did you see that the size of the pot is at a record $700 million – how could you not buy a ticket!)  Prospect theory only helps us understand decision-making.  It doesn’t actually make it rational.

These insights into how we, and our patients, make decisions may help us in practice.  There are several studies showing that parents and physicians differ in the values they assign to various short- and long-term outcomes, presumably because of different reference points.  Parents and patients also make different choices when the decision is framed in terms of a gain or a loss, for example, chance of survival versus chance of dying.  This all suggests a need to see the world through someone else’s eyes if we want to help them come to the best decision for them.  We need to understand the filters – theirs and ours.

It also helps us potentially make better business decisions.  Prospect theory suggests that in the face of a small chance for a large gain, we tend to reject choices with a much greater degree of certainty for something that is less lucrative.  For  example, if offered $2 in cash or a $2 lottery ticket, most people would take the ticket.  We don’t see either choice as a loss, and from our reference point the high likelihood of the small gain may not be worth forgoing the small chance to hit it big.  But a forgone gain IS a loss (I gave up a free cup of coffee).  This argues for a rigorous process for providing an objective calculation of the actual expected value of  each of the possibilities in a business decision.  As another example, “cutting one’s losses” may be the best strategy for avoiding further losses.  But we know that, because of the endowment effect, we tend to overvalue what we already have, which makes it emotionally difficult to let go even when that would make the most sense.

In  the meantime, while starting a brewery may not be in my risk comfort zone, the Old Bust Head beer is pretty tasty – trying one is no gamble at all.  (Alas, it’s only available in Virginia for now….)

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