Casinos thrive because people are wrong about the odds. The same can be said about investing. The reason why is what Daniel Kahneman calls the “single most important bias.”
The odds of most gambling games can figured out using grade school math. In a totally rational world, where everyone was out to maximize their money, nobody would play any game that favored the House. But not everyone plays for maximum wealth.
So there must be something else going on. Entertainment plays a part. The bells and flashing lights and the quick play bring thrills.
Really, some people think they’re the exception the odds. Ed Thorp calls gambling a tax on ignorance: “People often gamble because they think they can win, they’re lucky, they have hunches, that sort of thing, whereas, in fact, they’re going to be remorselessly ground down over time.”
Kahneman chalks it up to optimism combined with confidence. He explained how it fits in the context of investing during a 2005 interview:
I’m struck by the discrepancy between the meaning of the word “risk” as a technical term and as a word in the language. Technically, it is associated with variance, but in the language, risk means danger and the focus is on losses. I think that is fairly important.
I’d like to comment on the way in which people take irrational risks, not to deny that a lot of risk taking is rational, both by some individuals and by organizations. But at least two forms of risk taking part from rationality, and they have interesting consequences, certainly for individuals and possibly for markets, although as a psychologist I’m not equipped to talk about markets.
One is what I’ll call desperate risk taking, which is basically an unwillingness to cut losses. The other kind of risk taking that is psychologically interesting is optimistic risk taking. A very common reason for people to take risks is that they’re wrong about the odds. They simply don’t know the risk they’re taking. This is very easy to document, and I think it is the single most important bias of judgment. It is a really powerful optimistic bias, and it is accompanied by an overconfidence bias where people think they know things they can’t know. This is counterbalanced by a common reason for people to avoid risk — an unreasonably intense emotional response to losses that are very small relative to wealth.
So the picture of risk taking, as it looks from a psychologist’s point of view, is that you have a great deal of optimism, a great deal of loss aversion, and some desperate risk taking. Probably the most significant departure of people from the rational-agent model (and one that Harry Markowitz identified more than 50 years ago) is that people think of outcomes in terms not of wealth but of gains and losses, and they frame those very narrowly. So they make decisions or think of stocks one at time, and the time horizon is very narrow. This exacerbates all of the biases that I mentioned earlier.
Most Nobel Minds – CFA Magazine 2005