Here are two scenarios and in each scenario you are given two alternatives. Choose one of the alternatives in each scenario. Don’t spend too much time on it. Just choose the alternative that first comes to your mind.

Scenario 1. In addition to whatever you own, you have been given $1,000. Which of the following two alternatives would you choose?

A1: A sure gain of a further $500,
     OR
B1: A 50% chance to gain a further $1,000 and a 50% chance to gain nothing.

Remember your choice. Better yet, write it down and try to put it out of your mind.

Scenario 2: In addition to whatever you own, you have been given $2,000. Which of the following two alternatives would you choose?

A2: A sure loss of $500,
     OR
B2: A 50% chance to lose $1,000 and a 50% chance to lose nothing.

What was your choice this time? Did you choose the first choice both times? Or the second? Or were your choices different?

Did you think the two scenarios were different or the same? Technically they have exactly the same cash flows. In both cases if you chose the first alternative you had a sure gain of $1,500 while if you chose the second alternative you had a 50/50 chance of gaining $2,000 or of gaining $1,000.

When these scenarios were presented to two groups of subjects by researchers D. Kahneman and A. Tversky, they found that 84% of the subjects chose A1 in the first scenario while 69% chose B2 in the second scenario. In other words, most subjects chose the sure amount in the first scenario while most chose the gamble in the second scenario. (These and many other results are contained in paper by Kahneman and Tversky which appeared in Econometrica, 1979.)

If there are no other considerations, most people will chose a sure thing in preference to a gamble with the same average payoff. This explains the first scenario. So what was it that pushed so many people towards the gamble in the second scenario?

Kahneman and Tversky conclude that people don’t like the certainty of losing money so that they are even willing to gamble to lessen the likelihood of such an outcome. In other words, the pain of loss is more likely to influence a person’s behavior than the joy of gain.

Another part of the analysis is that the initial receipt of $1,000 in the first scenario and $2,000 in the second is not factored into the decision process. For example, in the second scenario, all that people see is the choice between a certain loss and a gamble in which they may lose nothing.

This is close to the notion of sunk costs, another area that leads to confusion in decision making. Robert Frank in his book Microeconomics and Behavior describes the case of two tennis courts at Cornell University, one indoor and the other outdoor. The indoor court has fees of $15 per hour and the outdoor court has no charge. Suppose you have already paid to play on the indoor court. You arrive to play on a warm, sunny afternoon and find that the outdoor court is free. Frank asks, "Where should you play, indoors or out?"

Frank reports that in surprisingly many cases people balk at playing on the outdoor court saying that they have already paid to play indoors. Even when he points out that the $15 fee is payable no matter which court they play on, it is a sunk cost, many still feel uncomfortable about ‘wasting’ the indoor court.

But something has to be wasted; either the $15 or the opportunity to play outdoors in the sunshine. In the end, both courts cost the same since $15 will be paid no matter which court is used. So if it is more pleasant to play outside in the sunshine, that is the rational choice.

Something similar can occur when we buy a stock that drops in price. Many people hesitate to sell such a stock even though they believe that they could get a better return with a different company. They hang on to the stock rather than ‘waste’ the money that is the difference between their purchase price and the current price. But, just as in the case of the fee for the tennis court, that money is a sunk cost. All that counts is what the stocks are worth now and how to get the best return on this money. (With stocks it is a little bit more complicated due to taxes and transaction costs.)

Another factor that can influence stock purchases is the effect of irrelevant information. In an experiment, groups of people were asked to choose between two apartments: the first is near the city but has a high rental, the second is further away but has a low rental. The experiment is set up in such a way that the split between the choices is roughly 50-50.

Then a third apartment is added to the list that is both further away than the second apartment and more expensive. Clearly this apartment is less attractive than the second one so you might expect that the outcome remains at 50-50 between the first and second apartments with none choosing the third. This is not the case. It turns out that the majority of people choose the second apartment.

The explanation is that people veer towards situations where there is a clear choice and away from more difficult choices. So they focus on the choice between apartments two and three and away from the choice between one and two.

These are just some of the irrational quirks associated with making decisions. If, as investors, we can be more aware of them and try to filter them out, then I believe we will be more successful. This is the main reason why I developed the Valuesoft Investment System to be able to apply definite quantitative methods when looking for long term investments and not to get side-tracked by irrelevant and misleading information.

You can get more information about the above topic and the Valuesoft Investment System, and a list of proposed topics, on my web site http://www.sherlockinvesting.com. Next month’s article "Why did I buy that stock?" will discuss the main investment strategies and how to implement them.