The Psychology of Risk

Each year millions of sports fans enter bracket pools for March Madness, the NCAA basketball championship.  Participants buy an entry or two for modest amounts like ten or twenty dollars.  Most who join in rarely, if ever, make even small wagers on specific sporting events.  March Madness  and the Super Bowl are different.

With tonight’s championship game we have an opportunity to use the bracket pool to gain a little insight on risk and how it affects behavior.  The situation described nearly always arises when the championship game is to be played.

A Typical Case

Let us suppose that a player enters a large bracket pool for \$25.  Through a combination of a few astute guesses and a lot of luck, our hero is in line for a useful prize.  If Kansas wins, he will win about \$1500.  If Memphis wins, he will win about \$1200.  A celebration will be in order either way.

When asked his opinion about the game, our ace handicapper tells us that it is a coin flip.  Why did he make the choice he did?  It was a close call, with no real reason to favor Kansas over Memphis.  Asked if he would make a bet on either team, our hero says "No."

Hedging, Anyone?

Let us now suppose that a friendly neighbor happens to be a big Jayhawk fan.  He offers to bet \$150 with the lucky pool prize-winner.  The effect of this bet would be that the expected victory will be \$1350, regardless of the outcome of the game.  Should he accept the bet?

Our experience, observing scores of friends and pool participants in these situations, is that they stick with their original entry.  They may think that it is "unlucky" to hedge — a silly notion since they are locking in a set amount.  They may think that it does not matter, since they are in for a nice prize either way.

True enough.  The \$300 difference may not seem like much when viewed in terms of the overall prize.  In a few days, however, when the contest has been forgotten, the result of the game will have a net effect of \$300 in actual spendable money.  A week later, the winner will be making decisions about saving a few bucks in amounts much smaller than \$300.  Even Doug Kass could fill up his Range Rover three times at the most expensive gas station in Palm Beach, Florida with the difference in prizes!

A Point of Comparison

By way of contrast,  let us suppose that our  pool  hero had failed to submit his entry on time.  Would he now be betting \$150 on Kansas?

Conclusion

While the situation here is, of course, completely hypothetical (err–Go Jayhawks!!), the circumstances cited are quite real.  Some of the winning disparities are much larger.

A key difference between professionals and the individual investor is the ability to assess and limit risk and to realize that every result counts.

You may also like

Finding Investment Excellence

• Rachel @ Master Your Card April 8, 2008

What a useful post. It has got me thinking about some of the small investment risks that I am taking and whether maybe I should be doing a little more to potentially get a much bigger return.

• VennData April 8, 2008

With Kansas favored by one and a half, you’re better off betting the dog.
Vegas sports books payout eleven for ten, bet a hundred and sixty five dollars to get your desired \$150 (two outcomes: lose \$165 or take \$315)
Expected payouts:
Kansas by two or more 1500 – 165 = 1335
Kansas by one 1500 + 150 = 1650
Memphis win 1200 + 150 = 1350
If Memphis loses by one win and the spread’s 1 1/2, you get both your Kansas win and your Memphis “hedge bet.”
You can shave the original \$165 to get a few more pennies optimally, but that’s the way to play a hedge.