Loss Aversion

Loss aversion is a bias, according to psychologists, where people attribute a stronger psychological weight to losses than to gains. Some psychological studies show that people place more weight on a loss, compared to a gain of the same size. This is labeled loss aversion.

Constructive Paranoia

constructive-paranoia
Constructive paranoia is a term coined by author, geographer, and ornithologist Jared Diamond in his 2012 book The World Until Yesterday. Constructive paranoia describes an appreciation (and respect for) low-risk hazards that are encountered frequently. In fact, frequency changes the degree of risk from low to high. Thus it’s important to recognize that seemingly low-risk endeavors, when performed frequently, can become highly-risky actions.

Polymath Jared Diamond, in his book, The World Until Yesterday, talks about constructive paranoia.

He learned this concept when leaving with several tribes in New Guinea.

For instance, those tribes had a cultural norm to avoid sleeping under big trees due to a seemingly irrational fear they might fall.

Indeed, there is a very low probability of that happening. And if you’re a statistician you’d think those people are mad. 

However, there is an important point to take into account.
If a big tree falls, no matter what, if you find yourself beneath, there is no way back, you’re dead.

And another critical point, is those people live in the forests, every day.
Thus, they are exposed to these big trees, frequently. 

In other words, frequency and expected outcome, make the tribe from New Guinea leverage constructive paranoia. This is what bounded rationality does. 

It helps us, naturally develop, antibodies against a world, that is noisier and noisier.

In most real-life scenarios, everyday people know that some domains of potential losses carry hidden risks, which as they can’t be computed, are ignored by psychologists, but instead are not hidden from the human mind.

So better be paranoid than a dead smart person.

Tribesmen know better while some modern psychologists have forgotten.

A labeling problem?

What if what’s been labeled as risk aversion – in some domains – is just constructive paranoia in a highly uncertain scenario? 

Take the case of how psychologists have analyzed the scenario where people feared more losing money than making money. 

Where the aversion of losing money is felt (psychologically) twice, compared to that of making money. 

But is this really irrational? 

I’ve been investing for a long time, and if there is one sure thing, it’s the asymmetry of loss. 

Take this very simple example. You have $1000 invested.
If you earn 20% you make $200 and you have $1200.
However, it only takes a 16% portfolio loss, to go back to $1000. 

Take the opposite scenario, you lose 20%, and you now have $800. 
Yet, to go back to $1000, you need to increase your portfolio by 25%. 

In other words, do you get the asymmetry here? 

If you earn 20%, you’ll get back with only a 16% portfolio loss.

But if you lose 20%, you need to increase your portfolio, by 25% to earn back the losses!

This means, that even if we do a bit of math, the brain seems to grasp that. 

Not only it, but our brain also seems to be wired to avoid the risk of ruin.
And modern society, and psychologists, do all they can, to make us forget, those built-in rules. 

To conclude, the real world is about satisficing!

satisficing
Simon’s satisficing strategy is a decision-making technique where the individual considers various solutions until they find an acceptable option. Satisficing is a portmanteau combining sufficing and satisfying and was created by psychologist Herbert A. Simon. He argued that many individuals make decisions with a satisfactory (and not optimal) solution. Satisfactory decisions are preferred because they achieve an acceptable result and avoid the resource-intensive search for something more optimal.

Psychologist Herbert Simon explained that in a complex world, you don’t want to optimize. You want to satisfice. 

Satisficing is about making a decision in an uncertain world, there information is incomplete, the problem is undefined, and the context is wide. 

And satisficing, in complex situations, work actually, way better than modeling. 

It’s, in short, the opposite, of what many business people do. With the proliferation of big data, they think they can easily model the world, forgetting that the model, is such a simplified version of reality, that it doesn’t work, in the first place. 

Not only that, the model, tends to stress a few (visible) metrics, that have the potential to kill the whole thing.

Indeed, one of the worst things startups can do is the so-called “premature optimization” or for instance trying to automate, important stuff, too early. 

Think of the case of a startup that doesn’t still understand what users appreciate about the project, automating right on, the demo of the product

This is bad because 1. the demo won’t be effective 2. the startup will lose an important feedback loop to improve the software, quickly 3. the first customers might also become your core channels, and in that stage, trust is the key, and you don’t want to automate that. 

That is why it’s critical, as a business person, you keep refining your BS detector, over time. 

Key takeaways

  • Loss aversion is not a bias. It’s the built-in detector, which makes humans avoid irreversible screw-ups. 
  • Satisficing is the process of using heuristics for decision-making in a complex world, and those, in most cases, work way better than complex scenario analyses. 
  • BS detector: as a business person your BS detector becomes the critical filter, and compass that helps you make decisions in a complex world.

Read this to understand the whole point.

Connected Business Concepts

Heuristics

heuristic
As highlighted by German psychologist Gerd Gigerenzer in the paper “Heuristic Decision Making,” the term heuristic is of Greek origin, meaning “serving to find out or discover.” More precisely, a heuristic is a fast and accurate way to make decisions in the real world, which is driven by uncertainty.

Bounded Rationality

bounded-rationality
Bounded rationality is a concept attributed to Herbert Simon, an economist and political scientist interested in decision-making and how we make decisions in the real world. In fact, he believed that rather than optimizing (which was the mainstream view in the past decades) humans follow what he called satisficing.

Second-Order Thinking

second-order-thinking
Second-order thinking is a means of assessing the implications of our decisions by considering future consequences. Second-order thinking is a mental model that considers all future possibilities. It encourages individuals to think outside of the box so that they can prepare for every and eventuality. It also discourages the tendency for individuals to default to the most obvious choice.

Lateral Thinking

lateral-thinking
Lateral thinking is a business strategy that involves approaching a problem from a different direction. The strategy attempts to remove traditionally formulaic and routine approaches to problem-solving by advocating creative thinking, therefore finding unconventional ways to solve a known problem. This sort of non-linear approach to problem-solving, can at times, create a big impact.

Moonshot Thinking

moonshot-thinking
Moonshot thinking is an approach to innovation, and it can be applied to business or any other discipline where you target at least 10X goals. That shifts the mindset, and it empowers a team of people to look for unconventional solutions, thus starting from first principles, by leveraging on fast-paced experimentation.

Biases

biases
The concept of cognitive biases was introduced and popularized by the work of Amos Tversky and Daniel Kahneman in 1972. Biases are seen as systematic errors and flaws that make humans deviate from the standards of rationality, thus making us inept at making good decisions under uncertainty.

Dunning-Kruger Effect

dunning-kruger-effect
The Dunning-Kruger effect describes a cognitive bias where people with low ability in a task overestimate their ability to perform that task well. Consumers or businesses that do not possess the requisite knowledge make bad decisions. What’s more, knowledge gaps prevent the person or business from seeing their mistakes.

Occam’s Razor

occams-razor
Occam’s Razor states that one should not increase (beyond reason) the number of entities required to explain anything. All things being equal, the simplest solution is often the best one. The principle is attributed to 14th-century English theologian William of Ockham.

Mandela Effect

mandela-effect
The Mandela effect is a phenomenon where a large group of people remembers an event differently from how it occurred. The Mandela effect was first described in relation to Fiona Broome, who believed that former South African President Nelson Mandela died in prison during the 1980s. While Mandela was released from prison in 1990 and died 23 years later, Broome remembered news coverage of his death in prison and even a speech from his widow. Of course, neither event occurred in reality. But Broome was later to discover that she was not the only one with the same recollection of events.

Crowding-Out Effect

crowding-out-effect
The crowding-out effect occurs when public sector spending reduces spending in the private sector.

Bandwagon Effect

bandwagon-effect
The bandwagon effect tells us that the more a belief or idea has been adopted by more people within a group, the more the individual adoption of that idea might increase within the same group. This is the psychological effect that leads to herd mentality. What is marketing can be associated with social proof.

Read Next: BiasesBounded RationalityMandela EffectDunning-Kruger

Read Next: Heuristics, Biases.

Scroll to Top
FourWeekMBA