Saturday, March 26, 2011

"The Sunk Cost Fallacy"

From You are not so Smart:
The Misconception: You make rational decisions based on the future value of objects, investments and experiences.
The Truth: Your decisions are tainted by the emotional investments you accumulate, and the more you invest in something the harder it becomes to abandon it.

You can learn a lot about dealing with loss from a video game called Farmville.

You have probably heard of this game. In 2010, one in five Facebook users had a Farmville account. The barrage of updates generated by the game annoyed other users so much it forced the social network to change how users sent messages. At its peak, 84 million people played it, a number greater than the population of Italy.

Farmville has shrunk since then. About 50 million people were still playing in early 2011 – still impressive considering the fantasy megagame World of Warcraft boasts about a quarter as many players.
So, it must be really, really fun. A game with this many players must promise potent, unadulterated joy, right? Actually, the lasting appeal of Farmville has little to do with fun. To understand why people commit to this game and what it can teach you about the addictive nature of investment, you must first understand how your fear of loss leads to the sunk cost fallacy.

Studies by psychologists Daniel Kahneman and Amos Tversky’s going back to the 1970s show you don’t equate loss and gain. Loss is more powerful. When they had subjects gamble in the lab, they noticed people tended to demand the promise of a payoff of at least double what they risked before they agreed to the terms of the game. Loss, they reasoned, was gain times two.

Outside of the lab, the pain you feel when you is lose cash is twice as strong as the joy you feel when you gain an item of equal value. This is why marketing and good salesmanship is often all about convincing you what you want to buy is worth more than what you must pay for it. You see something as a good value when you predict the pain of loss will be offset by your joy of gain. If they did their job well, somewhere in your Byzantine perception you feel as though you won’t lose at all. Emotionally, you will come out ahead. Unless you are buying something just to show others how much money you can burn, you avoid cringing when you fork over your earnings.

Imagine the apocalypse is upon you. Some terrible disease was unleashed in an attempt to cure male pattern baldness. The human population has been reduced to 600 people. Everyone is likely to die without help. As one of the last survivors you meet a scientist who believes he has found a cure, but he isn’t sure. He has two versions and can’t bear to choose between them. His scientific estimates are exact, but he leaves the choice up to you.

Cure A is guaranteed to save exactly 200 people. Cure B has a 1/3 probability of saving 600, but a 2/3 probability of saving no one. The fate of hairlines and future generations is in your hands. Which do you pick?
Ok, mark your answer and let’s reimagine the scenario. Same setup, everyone is going to die without a cure, but this time if you use Cure C it is certain exactly 400 people will die. Cure D has a 1/3 probability of killing no one, but a 2/3 probability killing 600. Which one?...MUCH MORE