By Diogo Gonçalves
Dear son, today I want to talk to you about how people make decisions. Many choices in our lives have uncertain outcomes. Choosing between two alternatives often involves a risk, such as whether you should spend your birthday money on a new bicycle or on a PlayStation. Each choice is like two sides of a coin: there is a risk of losing something (a loss) and an opportunity of getting something (a gain). If you spend your birthday money on a new bicycle you will lose the opportunity to spend your money on other things and gain the pleasure of having a bicycle and use it to ride through the neighborhood; if you spend your birthday money on a PlayStation you will lose the opportunity to spend your money on other things and gain the pleasure of having a PlayStation to play with your friends. Both alternatives involve gains and losses.
These types of choices are determined by three ways of thinking, which influence the way we evaluate the expected results of our decisions, and consequently, the choices we make.
1) The first one is called Loss Aversion
For us humans, losing something hurts more than gaining it. This happens because we are loss averse. In fact, the science of loss aversion says that losing something makes you feel sad twice as much (let’s give it two frownies 🙁 🙁 ) as you feel happy when you gain something (let’s give that one smiley 🙂 ). Losing your pencil case feels twice as bad ( 🙁 🙁 ) as getting a new pencil case ( 🙂 ). This means that, if you lose your pencil case and find it again the next day, you will feel three times happier (two from canceling the loss and one from the gain) than you felt when you first received it.
2) The second one is called Diminishing Sensitivity
I know you really like chocolate mousse. But when I give you chocolate mousse for dessert, the first spoonful of chocolate mousse tastes much better than the fifth spoonful, the fifth spoonful better than the sixth, and so on… This means that our sensitivity to things becomes smaller and smaller. If I turn on a dim light in your dark room while you are sleeping, it will have a big effect. But the same dim light may be hard to see in your bright room during the day. Similarly, if I cut your $20 allowance by $5, you will feel it more than you would if you had a $30 allowance, but less than you would if you had a $10 allowance, though the difference ($5) is the same in all three cases.
3) The third one is called Reference Point
Imagine you drink a cola with ice after having a warm soup, or after having an ice cream. The cola will seem colder after having the soup than after having the ice cream. This happens because your mouth gets used to a reference point (warmth with the soup and coldness with the ice cream) that determines the way you experience the same cola. When people think about money they also use a reference point, which is usually what you expect, or feel entitled to. Outcomes that are better than the reference point are perceived as gains, the ones that are worse are perceived as losses. So if you are used to receiving $200 from your grandmother for Christmas and she gives you only $150 this year, you will feel like you lost something. But if you had received $100 in the past, this year’s $150 will make you feel like you gained something.
These three principles revolutionized a science called economics, which deals with the way we think about money. More recently, a new kind of economics emerged, which has introduced psychology – the science of the mind – into economics. This field is called behavioral economics. Understanding its ideas can help everyone, including you, make better decisions.