How about a thought experiment?
Imagine you are walking along the street when a man approaches and offers you a gamble. The terms are simple. He will flip a quarter. If it lands on heads, you will get $2. He will continue to flip the quarter, paying you twice the amount earned on the previous flip, until it lands on tails. Once it does, whether it be the first or thousandth flip, the game ends and you are paid out. For example, if the coin lands on heads the first three flips and tails on the fourth, you will receive $16 (see below).
- Flip 1: Heads = $2
- Flip 2: Heads = $4 ($2 x 2)
- Flip 3: Heads = $8 ($4 x 2)
- Flip 4: Tails = $16 ($8 x2)
Theoretically, the coin could continue to land on heads indefinitely. As a result, there is a probability, albeit very slim, that your earning potential in this gamble is unlimited. Now that the man has your interest, he asks:
“How much are you willing to pay for this gamble?”
This revolutionary question was asked by Daniel Bernoulli in the ripe old year of 1738. Like so many other questions asked during the enlightenment era, this one would have significant ramifications, influencing how economists and psychologist would come to understand the way people make financial decisions under uncertain conditions. Bernoulli determined that, even with the prospect of infinite gains, people were typically only willing to pay $4 (ducats in Bernoulli’s case) for the gamble.
It also offers insight into how people make financial planning decisions. As they view their situation through a narrow scope that limits their understanding, their sense of uncertainty increases. The result: risk aversion, which can lead to them maintaining the perceived safety of their status quo. Unfortunately, the status quo is often not going to help their situation, nor is it always stable. This is why an advisor who guides their clients by broadening their understanding and frame-of-information will empower them to make better decisions – not based in fear and uncertainty, but knowledge and empowerment.
So, how much were you willing to pay for the gamble? Let me in the comments below.
Want to learn more about how people make decisions under uncertainty? Checkout my video, Framing Communication for Client Behavior. If you like it, follow my YouTube channel for more!