In prospect theory, we have seen how human psychology slips into irrationality while understanding risks. The fourfold pattern is one such representation; of behaviours that deal with extreme probability events.
Imagine the following four cases of improving the chances of making one mln dollars.
A. 0% to 5%
B. 5% to 10%
C. 50 to 55%
D. 95 to 100%
A robot will perform the following calculations and conclude
A. (0.05 x 1,000,000 + 0.95 x 0) – 0 = $50,000
B. (0.1 x 1,000,000 + 0.90 x 0) – (0.05 x 1,000,000 + 0.95 x 0) = $50,000
C. (0.55 x 1,000,000 + 0.45 x 0) – (0.5 x 1,000,000 + 0.5 x 0) = $50,000
D. (1.0 x 1,000,000 + 0.0 x 0) – (0.95 x 1,000,000 + 0.05 x 0) = $50,000
that, all those situations lead to the same outcome – the robot has just performed an expected value calculation! But humans are not robots, and not all increment (wins or losses) has the same value.
A change from 0% to 5% is a movement from impossibility to a ray of hope. And that triggers the brain disproportionally. In other words, we overestimate that 5%. A classic example is a lottery ticket. How many of us would buy a ticket that expired a month ago? In reality, the chance of winning a lottery is almost the same as that of an expired one! This behaviour is called ‘risk-seeking‘.
On the other hand, progress from 95% to 100% is a change from possibility to certainty. An example is an out-of-court settlement. Assume you have a 95% chance of winning a lawsuit at $1 mln. Your lawyer indicated a 5% chance of losing the case and conveyed the other party’s willingness for a settlement of %750,000. Will you take it? This is ‘risk aversion‘ or underestimation of probability.
