Photo by markmiller

In today’s fast-paced world, we are often too busy with current events that we never really sit down to truly know what we want for ourselves in the future. When you do think about what your long-term goals and dreams are, let me warn you about the Allais paradox.

Suppose you have to pick from two choices: (A) $1 million guaranteed, or (B) a coin flip to see if you get either $5 million or nothing. If you were like most people, you would pick the $1M option because it’s the sure thing, even though the expected value of the second choice is $2.5 M (half of $5 M), which is more than (A). The fact that most people would go for (A) rather than (B) is called the Allais paradox.

What’s happening is that since the first choice was the sure thing, the second choice really becomes a 50/50 chance of getting $4 M more or lose $1 M. Daniel Kahneman helped to develop prospect theory to explain people’s response to real-world risks. Two main points come from prospect theory: 1) the aversion to loss is stronger than the desire for gain, and 2) people calculate gains and loss not on an absolute scale, but based on their own point of reference. The following diagram shows that the decrease in value is faster as you lose compared to the increase in value as you gain. Also, you can see that most of the change in values occur near the central point of reference - at some point along the line, the value from gaining won’t increase much, even if the outcome changes a lot.

Source: Wikipedia

The impact of the prospect theory was significant enough that Kahneman was awarded a Nobel prize in economics. What makes it really interesting was that Kahneman was not an economist, but a psychologist! This phenomenon goes beyond economics; prospect theory explains general human behavior.

In economics, the value would be money, but in life, the value would be our emotions. The graph shows that if we set personal goals at a certain value, a significant increase with the outcome won’t increase our value of it much. We would not appreciate the additional gains - in other words, we would be selling ourselves short.

We can reduce the effect of selling ourselves short by understanding that we can choose our emotional reference point and shape how we respond to gains and loss. By increasing our reference point at a higher level, we can better appreciate higher gains. If we can manage our emotional response to gains and losses, we can better appreciate bigger goals and stop selling ourselves short.

Now that you have been warned of the Allais paradox, are your goals still the same, or are you considering being more aggressive?