Would You Rather

Would you rather gain 10% of your money, or have a 10% chance to double your money

For the economists, mathematicians, analysts, and all the rest of you out there, assuming you have $100,000 and are faced with a choice, what would you rather.

1. Scenario A: gain 10%, means getting $10,000
2. Scenario B: have a 10% chance to double your money, means you would gain $100,000.

The expected value of scenario A is 100% times $10,000, which equals $10,000.

The expected value of scenario B is 10% times $100,000 which equals $10,000.

While both scenarios are mathematically equal in expected value, some people place more weight in having certainty while others might value the opportunity to have a larger (potentially life changing) amount and take the gamble.

Now, what happens if it is losses.

Would you rather lose 10% of your money,

or have a 10% chance to lose all you money

Once again, let's assume you have $100,000.

1. Scenario A: lose 10%, means losing $10,000
2. Scenario B: have a 10% chance to lose all $100,000.

The expected value of the loss in scenario A is 100% times $10,000, which equals $10,000.

The expected value of the loss in scenario B is 10% times $100,000, which equals $10,000.

Both are equal in terms of expected value of the loss. However, when I present these scenarios, a larger portion of people seem to prefer to take the definite loss.

This is especially true for businessmen and investors. A wise businessman told me that it is an obvious choice for him to accept the known loss. As a businessman, he would never take such a gamble that risks his business and the livelihood of his employees, even if it is a one in ten chance.

In investing and trading, a stop-loss order plays a similar role - to cut the losses in the event the price goes against you.

Regardless, I believe that everyone's situation and risk appetite differs. Did your choices change when it became losses? Which would you rather?