Sunday 21 August 2022

Risk Is Personal

One of the accounts I follow on Twitter is Clifford Pickover and last week he Tweeted the following:

At the time of writing, it has garnered almost 1,500 replies, with a number of differing opinions, and one unfortunate individual saying:
I am color blind. Which is which?
There's always one, as my Mother used to say.

While it's unlikely any of us will ever find ourselves in the fortunate position of deciding which button to press, it's an interesting thought experiment.

Mathematically speaking, it's a no-brainer. The green button has an expected value of $25 million, the red of $1 million, and so you should press green every time, but we're human beings, not robots. 

Losses hurt and our personal circumstances tend to outweigh the mathematics when it comes to big financial decisions.

If you are a billionaire, you (presumably) press green, but if $1 million is a life-changing sum for you, it's not unreasonable to press the red button and take the guaranteed $1 million. 

The question gets interesting when it's applied to people with some money. What if you have $1 million already? It might hurt to miss out on doubling your money and you may well choose red, but what if you have $5 million? 

Risk is personal and our individual circumstances make a difference.

The 18th century mathematician Daniel Bernoulli came up with the idea of "utility" and understood that real-life decisions are dependent on an individual's circumstances. 

Someone posted a follow up poll, with the following results:
I wonder how close those numbers would be in a real-world scenario? 

1 comment:

Jason said...

Hi Cassini,
This (very loosely) reminded me of a podcast I listened to recently, on the subject of hedging.
Not sure if you're a listener to the Bet The Process podcast, but within the last couple of months (Season 5 Episode 32) there was a discussion on whether to hedge out of a bet even if the hedge itself is a bad value bet.
At around 25 minutes in the discussion covers the use of Kelly in relation to hedging out of a bet, even at a negative edge, when considering what you stand to win in relation to your bankroll/personal wealth.
I can't really comment on the maths (although I'm sure you can), but thought it might be of interest when considering the follow-up poll referenced in your piece (where the responders are asked to consider the effect of net worth on their choice between red and green).
Hope this is of some interest to you.
All the best,