This blog post calmly examines how probability, risk, human psychology, and cognitive biases cloud rational judgment during investment and decision-making moments. It explains the process by which uncertainty distorts judgment through concrete examples.
Principles of Investment and Finance
When I mention I majored in economics, many people ask which stocks seem likely to rise. Indeed, economics and investment theory share significant overlap, with several key principles of investment theory grounded in economic theory. This chapter focuses on the points where economics and investment theory intersect. Specifically, it centers on understanding how to manage risk, what diversification entails, and how human psychology and irrational expectations influence decision-making. Furthermore, if you can connect these concepts to the macroeconomic trends discussed earlier, you will be able to interpret what macroeconomic news means for your investments.
This book does not directly cover accounting knowledge needed to identify promising companies or industries in growth phases, nor does it provide specific regional information required for real estate investment. However, understanding the principles of investment and finance will provide a foundation for gaining deeper insights into other specialized knowledge.
If you had to choose between $10 million with a 100% probability or $100 million with a 50% probability, which would you pick?
I once saw a scene on an internet variety show where two hosts debated which option was better: a 50% chance of receiving $100 million, or a 100% chance of receiving $10 million. One argued that the guaranteed $10 million was better, while the other said they would choose the option with a 50% chance of receiving the massive $100 million. It’s a delightful dilemma to ponder. If asked to choose simply between $100 million and $10 million, most would pick the $100 million. But the moment probability enters the equation, the deliberation begins.
People’s Attitudes Toward Probability and Risk
The first step to understanding uncertain choices is distinguishing between the concepts of probability and risk. For example, imagine flipping a coin: heads means you receive $10, tails means you pay $10. The probability of heads or tails is each half, allowing us to precisely determine the likelihood of each outcome. Similarly, with the lottery, since the prize and winning probability are publicly disclosed, people decide whether to buy tickets based on this information. When probability is clearly defined like this, we can calculate the expected value. This involves assessing the average profit one can expect when considering the probability, and a higher expected value is more favorable.
Beyond this, risk is another crucial factor to consider. Even with the same expected value, risk exists because the outcome can vary probabilistically. People generally tend to dislike this risk, though the degree varies from person to person. For example, consider comparing receiving $1,000 unconditionally versus flipping a coin and receiving $2,000 if it lands heads. Purely in terms of expected value, both options are identical. Nevertheless, most people choose the first option. This preference for the more stable choice is called risk aversion.
The degree of risk aversion varies from person to person. While some individuals strongly avoid risk, others have a relatively lower aversion to risk and will choose the risky option if the expected value is sufficiently high. Therefore, people’s choices vary greatly depending on various conditions such as the size of the prize and potential loss, an individual’s risk tolerance, and the current size of their assets.
Comparing a $10 million prize guaranteed with 100% probability to a $100 million prize with a 50% chance of winning, the probability difference is only twofold, but the monetary difference is tenfold.
However, while $10 million is guaranteed, $100 million carries a 50% chance of receiving nothing. Someone with a strong risk-averse tendency might prefer the certain $10 million. Conversely, someone who is risk-neutral or relatively risk-seeking might accept the risk of getting nothing to increase the chance of receiving a large sum.
The individual’s financial situation also plays a crucial role. For someone with a stable job and family, the value of $100 million isn’t merely ten times that of $10 million; it could fundamentally alter their quality of life and options. Conversely, for someone carrying approximately $7 million in debt, the most pressing priority might be to pay off that debt as quickly as possible and sever ties with creditors. In this case, the guaranteed $10 million becomes a far more important and valuable option than the $100 million with a 50% chance of being received. There is no single correct answer to this problem. Ultimately, the choice that brings you greater satisfaction is the right one.
The Thrill and Tension of Risk
The previous example involved clearly known probabilities, but in reality, situations where exact probabilities are unknown are far more common. We distinguish between risk, where the probability is known, and uncertainty, where the probability itself is unknown. In situations of uncertainty, one must estimate and gauge unknown probabilities. While a cool-headed analysis based on sufficient information can predict probabilities to some extent, this process is easily influenced by emotions, impulses, and various psychological biases. As a result, making rational choices becomes even more difficult.
Generally, the human brain is designed to avoid both risky and uncertain situations. Yet, why do so many people easily become addicted to games of chance like horse racing or gambling? It is because the pleasure derived from these activities is immense. In games of chance, individuals can decide the size of their wager and place bets themselves; this process of choice stimulates dopamine release, intensifying the sense of reward. Furthermore, the thrill intensifies because the outcome isn’t determined immediately; the tension persists until the result is revealed. The psychology of someone choosing a $100 million prize with a 50% probability also aligns with these factors. The excitement and tension generated by probabilistic choices are so significant that they can override the natural tendency to avoid risk, or even lead to risk-seeking decisions.
People also tend to overestimate their choices. They may hold excessive confidence in their abilities or the information they possess, or overestimate the probability of a favorable outcome. Even when the overall stock market rises and they profit, they easily misattribute this to their own investment skills rather than market conditions. Repeated experiences reinforce this overconfidence.
During the period from late 2020 to 2021 in Korea, when stock and virtual asset prices surged sharply, expressions like “Certain company stocks never fall,” “Real estate prices never decline,” and “Money is being printed” spread like a fad. However, as the trend of interest rate hikes gained momentum, asset prices underwent significant corrections, and many investors experienced substantial losses. This case clearly demonstrates how difficult it is to predict asset price movements objectively.
Another common error is survivorship bias. This cognitive error occurs because successful people are highly visible, while those who failed are relatively harder to observe. Successful stock investors often actively share their experiences or engage in public activities like lectures. Conversely, failure stories are rarely visible. Consequently, success probabilities estimated based on personal experience or surrounding examples tend to be overly inflated compared to reality.
Efforts to Overcome Errors
Due to human cognitive structures and psychological biases, it is extremely difficult in reality to rigorously predict the likelihood and probability of events and make rational choices. To overcome this, one must first recognize their own cognitive biases and make efforts to compensate for them. One must realize that success probabilities formed based on personal experience or perception are likely to contain errors. It is crucial to seek out and verify data based on statistical analysis, or at the very least, adopt an attitude of not holding excessive confidence in one’s own information.
Another method is to preemptively identify and control one’s impulsive tendencies or emotional reactions. If the thrill derived from horse racing games is excessively strong, the most effective response might be to simply avoid going to the racetrack altogether. If investing in stocks causes excessive anxiety over price fluctuations that disrupt daily life, efforts like stopping investments or deleting investment-related apps to reduce frequent checking may be necessary. Alternatively, choosing indirect investment methods like funds instead of investing in individual stocks could be a better alternative.
The uncertainties of reality make personal choices even more difficult, easily entangling even those who strive for rational judgment in irrational cognitive biases and emotions. However, by recognizing the existence of these errors and making a deliberate effort to overcome them, one can take a step closer to making better choices, even if they are not perfect.
