## Wednesday, July 27, 2011

### A Theory about Risk Aversion

It is well known that people often make irrational financial decisions even in fairly simple situations where they have all the information they need to make a good decision. I have an idea about why we are this way that is so simple that it is very unlikely to be original, but I couldn't find this idea in other writings in a quick search.

One simple model of the value (or utility) of money is that each doubling of your savings has the same incremental value. So, if you start with \$100,000, dropping to \$50,000 is as detrimental as doubling to \$200,000 is beneficial. For small gains and losses, the sizes of steps of equal utility differ by less. For example, a loss of only \$1000 is as detrimental as gaining \$1010 is beneficial.

However, throughout most of human evolution, great wealth for a single individual did not exist. Before the advent of storing food, a large kill would only last until the meat rotted or was taken by other hungry people or animals. We are simply not suited to making decisions about large amounts of wealth.

In modern times, if you are offered a 50/50 chance at winning \$20 or losing \$10, and you’re satisfied that the game is fair, it is rational to take the chance. However, an ancient human or pre-human might make a different calculation because he is always just a few missed meals from death.

Suppose that a hungry ancient human could either stay with a small kill to eat a day’s worth of food or take off after larger prey for a 50/50 chance of either getting triple his need for the day if he succeeds or going hungry the rest of the day if he fails. It seems perfectly rational for him to take the safe choice, fill his belly now, and hunt again the next day.

This line of thinking may also explain lottery tickets. Early humans used to routinely walk away from wealth. Once the belly is full, extra meat or berries have little immediate value. It makes sense to give away small amounts of food you don’t need right now in return for a shiny rock or even just the prospect that the receiver might give a favour in return some time in the future.

So the theory is that we are not well adapted to making decisions about years worth of wealth. We tend to make decisions about small amounts of money as though we have very little, even if we actually have enough money to survive for months or years.

1. Interesting post, though I suspect anthropologists would cringe at the broad generalizations....

But I think the main point holds: there's no reason for evolution to have equipped us for decisions which effect more than a years survival.

Then again, agriculture has existed for at least 10 000 years, so you'd think some medium-term planning should be "hard-coded" by now. But decisions based on numbers of an abstract quantity are hard to make decisions on, too (and not just selling cattle to have more grain) and they're very recent (500-1000 years, I guess)
-Paul G.

2. @Paul: If I turn out to be generally correct, I'm not too concerned if the ideas have rough edges. I have no idea how long it might take for evolution to make a difference. However, the link between ability to make good decisions about wealth and producing offspring seems pretty weak in modern society.

3. I remember the words of a friend of mine when I was young and playing poker: "The idea is when you win, to win a lot and when losing, losing as little as possible". Life should be that way. Going for small winnings and consolidating them is more important than dreaming big winnings. To follow your analogy: I think that early man would do whatever it is possible to get through the day... to reach the one where hunting an elephant has real chances of success!

4. Very interesting theory, likely with a good degree of accuracy, though I am no anthropologist...
I just finished reading - and highly recommend - 'Sex at Dawn', which also touches on evolution, albeit focused on human relationships and sexuality.
One key point from the book is that while agriculture has indeed been around for 10,000 years, it represents merely 5% of the total time our species (Homo Sapiens) has been around. Just as this has consequences in human relationships (read the book...) it also would likely validate the theory that we haven't yet adapted to dealing with large quantities of wealth.

5. @Fernando: Sounds like an interesting book. Thanks for the reference.

6. I like it, I like it a lot. When considering the conditions in which our ancestors lived, it's no wonder we have trouble thinking long term. I never thought of this until I read your post.

Counteracting this lack of forward-thinking in early humans, I suppose, is the propensity of less evolved species to hide caches of food for lean times. Squirrels, dogs, and large cats do this, don't they?

Perhaps we are told the fable of the ant and the grasshopper to instil some long-term thinking into our brains as children.

Thought provoking post, Michael.

7. @Gene: It's true that some animals try to store food. Maybe pre-humans did this to some degree as well. Still, this isn't adequate preparation for making decisions about enough wealth to sustain all our needs for a year or more.