Prospect Theory: How to turn $100 into $200 - YouTube

It's your friendly neighborhood Andrew here,  and today I have a money question for you.  

Your friend Paul asks you to flip a  coin: if it's heads, he'll give you  

$200; if it's tails, then you have to  give him $100. Is that a good choice?  

In this video I'm going to cover exactly  why you are going to struggle converting  

a hundred dollars to two hundred dollars anytime  soon and why that is baked into your human nature  

today we're not trying to talk about bitcoin or  anything crazy like that we're gonna talk about  

money decisions why you have such a hard time  transitioning a hundred dollars into two hundred  

dollars and the money mistakes that you make  without even knowing about it oftentimes the  

questions to life are hidden away in books like  these i'm trying to boil it down for you questions  

like how do i hack my growth and find financial  freedom and how do i smash the like button for  

the youtube algorithm and send my appreciation to  andrew and his channel if you are new here please  

subscribe because i appreciate that a ton and  let's get started the paw that i was talking about  

is paul samuelson he was a giant in economics  and i read about him in this book thinking  

fast and slow by daniel kahneman paul asked his  friend about the 100 versus 200 bet an obviously  

good bet on average and this is what his friend  said i won't bet because i would feel the 100  

loss more than the 200 gain but i'll take you on  if you promise to let me make a hundred such bets  

so what hold on this means that he won't do it  once but he would do it if you promised to let him  

do a hundred times now hold on a second shouldn't  utility maximizers like paul samuelson and his  

economist friend think rationally that is to say  a gamble of one should be equally pleasing than  

a gamble of many well this goes back to prospect  theory and that is at the core of why you are not  

gonna be able to turn a hundred dollars into two  hundred dollars money almost fell into the trash  

in prospect theory a mixed gamble where a coin  flip can make you win or lose causes immense  

risk aversion that means that you are a lot more  afraid of losing a hundred dollars than you are  

hopeful that you'll win 200 professor meatball  the dog is offering you a chance to invest in  

his doggy daycare he promises that if you put in  a hundred dollars there is going to be a 50 chance  

that you come out with 200 or nothing this comes  down to the very basic ideas of investing if you  

let a dollar sit and just do nothing with it for  30 years graham stefan in his video said that that  

would become a tenth of what it's worth now and  this is bad for you letting your money just sit  

and not investing it or putting it somewhere that  has a growth potential allows you to fall prey to  

the idea that money deprecates over time the thing  with professor meatball's investment plan is that  

yes there was a chance that you would fail and  lose your 100 investment but the equal chance was  

to double your bet and come out with 200 let's go  back to paul and dig into a little more economics  

i'm sorry it's gonna get a little dry but here is  an actual book since prospect theory asserts that  

you are risk-averse and you would weigh potential  losses twice as heavily as potential gains that  

means that we can rewrite the equation that your  potential losses are 2x what they actually are so  

in your mind you're losing 200 and gaining 200  well in that first bet then your expected value  

is zero so of course you wouldn't take the bet  because you're risk averse however if we did it  

twice if we started increasing the number of times  we flipped the coin and made the same bet then  

we see an interesting change the expected value  starts to rise you should expect to see a hundred  

dollar net gain after two flips of the coin maybe  you lose a hundred dollars but then you gain  

two hundred dollars that's the wrong way maybe  you lose a hundred dollars but then you gain  

two hundred dollars but even if you weighted  your losses twice as heavily as your gains  

you would still have a net positive expected value  that's because the chances of you losing twice are  

equal to the chances of you winning twice so those  two expected values cancel out but you're still  

expected to see a mixed bag maybe you win one and  then you lose one the expected value from that  

mixed bag of lose win or win lose is positive you  have a 50 chance of winning a hundred out of two  

coin flips so we can't double that because it's  not a loss anymore now that fifty percent chance  

of winning a hundred becomes an expected value  of fifty fresh moolahs two independent gambles  

both are coin flips and both awards you with two  hundred dollars if you win and a hundred dollar  

loss if you lose both of which would be useless  to you if you valued losing money twice as much as  

gaining money a net value of zero that you would  turn down both times suddenly becomes enticing  

this is how a trader thinks you win some and you  lose some even if individually your risk appetite  

would reject one of these gambles together by not  putting all your eggs in one basket and betting on  

two independent gambles you suddenly have value  it gets even better at three remember the third  

toss is independently valueless if taken by itself  the expected value of three independent gambles  

together is a hundred and twelve dollars that  is even more sixty two dollars more in fact than  

two tosses it gets even better at five tosses  where its expected value is 250 and the chance  

that he'll lose anything at all is only 18.75 you  see one choice that would have been rejected at a  

narrow frame is suddenly very profitable when you  take it on a broad frame this is how traders think  

humans tend to think risk-aversely that's the  entire crux of prospect theory but if you think  

like this you will never be able to grow wealthy  and start that seed of your finance in fact daniel  

kahneman actually wrote a sermon to those of you  that are risk averse for single highly beneficial  

gambles such as paul's friend allow me to  read it to you in a dramatic interpretation  

i sympathize with your aversion to losing any  gamble but it is costing you a lot of money please  

consider this question are you on your deathbed  is this the last offer of a small favorable gamble  

that you will ever consider of course you are  unlikely to be offered exactly this gamble again  

but you will have many opportunities to consider  attractive gambles with stakes that are very small  

relative to your wealth you will do yourself a  large financial favor if you are able to see each  

of these gambles as a part of a bundle of small  gambles and rehearse the mantra that will get you  

significantly closer to economic rationality you  win a few you lose a few the main purpose of the  

mantra is to control your emotional response  when you do lose if you can trust it to be  

effective you should remind yourself of it when  deciding whether or not to accept a small risk  

with positive expected value remember these  qualifications when using the mantra three  

caveats one this only works if the gambles  are genuinely independent of each other  

so this doesn't apply to multiple investments in  one industry which could all go south together  

two this only works when the possible loss does  not cause you to worry about your total wealth if  

you would take the loss as significant bad news  about your economic future watch it and three  

it should not be applied to long shots where the  probability of winning is very small for each bet  

if you're given these three caveats you will be  in good shape to start thinking like a trader  

so how do you avoid this logical trap well let  me tell you a little something that will change  

your perspective all together and avoid costly  financial mistakes in the future this is a mistake  

of narrow framing versus broad framing and you  make this mistake every single day a narrow  

frame would be if you walk down to the store and  you notice that the price of eggs has gone up 30  

well that might actually prevent you from  buying any eggs today that's such a huge  

increase in a small choice however a much larger  choice like going to college and having to pay  

thousands of dollars per hour of tuition you are  certainly going to make that choice a lot more  

flippantly even if the price of tuition continues  to rise 10 20 year after year you're thinking of  

the benefits of going to college such as getting  an employment that pays off the college tuition  

but you hardly think about the debt by nature  humans are narrow framers and they constantly  

think about the margin of an individual choice  anything that you can understand you're going to  

have more scrutiny such as whether or not you're  going to go and drink a coke or a pepsi but you  

hardly think about what a much larger decision is  going to do for you such as investing in bitcoin  

or tesla stock today humans hardly ever think  about the value of your dollar slowly decreasing  

and investing 100 today can easily become 200 in  a few months or a year this is the fundamental  

prospect of compound interest theory again  remember to think like a trader you are a smart  

person but you are probably thinking too narrowly  if you have your narrow frame of mind you will  

constantly make bad choices that will affect  your future wealth remember to think broadly  

and read some books the big questions in life  are often solved by scientists who have already  

wrote these books into existence however so few  of us read for pleasure that's why this episode is  

brought to you by audible i want you to go out and  maybe think about this book thinking fast and slow  

i've been working through it for about 20 minutes  a day every single morning thanks to charlie chang  

and other productivity experts i think that  reading a couple minutes a day can really help  

out and if you don't have time to sit down and  have a quiet space maybe when you're walking down  

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although it does help me if you go and buy me a  coffee as always see you guys next time peace you