2 Scenarios – What are your choices?

Scenario 1

Imagine, I made you two offers:

1. Offer A: You have a 50% chance of making $3300 and a 50% chance of losing $3300.
2. Offer B: You have a 100% chance of making $2000.

Which will you choose? I reckon most people will choose Offer B. I probably would take Offer B.

Scenario 2

Now I again made you two offers:

1. Offer A: You have a 50% chance of losing $3300 and a 50% chance of losing $0.
2. Offer B: You have a 100% chance of losing $2000.

I reckon most of us will choose Offer A.

Of course, not all of us will make the above decision eg. Choosing Offer B in Scenario 1 and Choosing Offer A in Scenario 2.

In fact, for many Singapore retail investors now, the above scenarios are very real.

In Scenario 1, imagine you have a war chest of approx $100k (just cash, let’s not go into SRS).

You can (Offer A) buy $100k worth of OCBC stocks that currently have a dividend yield of 3.269% which should give you approx. $3269 worth of tax-free dividend income. However, given the current volatility of the stock market, you might end up losing $3300 overall (or more) by the 2019 year end.

OR You can (Offer B), buy $100k worth of Singapore Saving Bonds that yield you approx. 2% in the 1st year, which will give you approx. $2k tax-free and is almost 100% risk-free.

In Scenario 2, imagine you are sitting on an un-realized loss of $2k from a stock. By selling now, you would have a 100% chance of losing that $2k (Offer B). However, by waiting it out, you might turn your $2k un-realized loss to zero or make it worse eg. becoming a $3.3k realized loss (Offer A).

Ok, I reckon the weightage in amount is not exactly the same in both Scenario 1 and 2.

However, I guess there is some truth in what two psychologists, Kahneman and Tversky’s Prospect Theory hypothesized. Prospect Theory contends that we value each of the components of a final outcome differently as well, basing decisions on perceived gains rather than perceived losses.

“We have an irrational tendency to be less willing to gamble with profits than with losses. This means selling quickly when we earn profits but not selling if we are running losses.”

In gist: Loss Aversion. Losses loom larger than gains.

However, if we think deeper, not all people adhere to the above choices. They might choose Offer A in Scenario 1. Then we start to question why would they choose to go for Offer A.

The theory made some assumptions.

The theory is applicable if there is a neutral reference point. Eg. we are assuming all participants have the same wealth.

But in reality, $2k means different things to different people. To someone with a $5 mil net worth, $2k relatively insignificant as compared to someone who has only $100k (and part of it might be borrowed). Eg. Diminishing sensitivity.

Or it could from a different Reference point. For someone who started with zero and made $1k, he might feel better than someone who made $2k and lost $1k. The former view it as a profit, while the latter view it as a loss (although both end up with $1k profit).

People are after all complex beings. Some seasoned investors just intuitionally go against the trend.

I reckon there are other factors, whereby people are all under different circumstances. For instance, people tend to be more risk-averse when they put all they have in, or they are in dire need of cash etc.

Cognitively we can skew this psychological bias, if we are aware of what are the factors.

Or there might be a simpler answer – they basically maxed out their purchase of Singapore Saving Bonds hahaha…