Risk Aversion and Real Life

No doubt, you have read some interesting book or article and the next thing you know, it is playing out in real life. Well, this blog is about just that.

I am still trying to muddle through Thinking Fast and Slow by Daniel Kahneman (Farrar, Straus and Giroux, New York, 2011). As it is dense reading, requiring System 2 thought, it is taking me awhile. I am getting towards the end of the book in which Dr. Kahneman discusses prospect theory also known as decision making; why and how we make the decisions we make. (Id. at 300-309.) As he explains it,

…choices between gambles and sure things are resolved differently, depending on whether the outcomes are good or bad. Decision makers tend to prefer the sure thing over the gamble (they are risk averse) when the outcomes are good. They tend to reject the sure thing and accept the gamble (they are risk seeking) when both outcomes are negative.” (Id. at 368.)

Thus, he addresses the well-known topic of “risk aversion”, or how people tend to avoid risk. As he puts it, “… losses loom larger than corresponding gains.” (Id. at pp.  297, 300.). Simply put, “Loss aversion refers to the relative strength of two motives: we are driven more strongly to avoid losses than to achieve gains.” (Id. at 302.) As an example, he posits the following questions:

Problem 1: Which do you choose?

Get $900 for sure OR 90% chance to get $1,000?

Problem 2: Which do you choose?

Lose $900 for sure OR 90% chance to lose 900? (Id. at 279.)

If you are like most people, in Problem 1, you will choose the $900 for sure as you are adverse to taking any sort of risk, but in Problem 2, you will take the gamble of 90% to losing $900. (Id. at 280.) Why? “…people tend to be risk seeking when all their options are bad.” (Id.)

With this in mind, Dr. Kahneman with Amos Tversky discovered a four-fold pattern into which people will fall in making a decision whether to settle a matter or proceed with the litigation. The pattern which looks like this:

( Id. at p. 317.)

I happened to read this page the day before an appellate mediation. I studied it and given the facts of the case, realized that the matter probably would not settle if this pattern held true.

The plaintiff was a tenant in a shopping center who claimed that she lost business because there were not enough parking spaces due to the large volume of business being conducted by other tenants in the shopping center. It is not clear whether the landlord, a corporate entity, tried to remedy the problem. Eventually, the tenant sued for breach of the lease and the matter was tried by a judge. The judge found that the landlord had breached the lease by not providing a sufficient number of parking spaces to the tenant for her customers. The judge awarded damages to the tenant of $500,000 and also awarded attorneys fees of $250,000 against one of the individual owners of the corporate landlord.

At the time this litigation was going on, the landlord was trying to sell the shopping center. Because of the litigation, it could not close the transaction with any interested purchasers. As a consequence, the holder of the trust deed on the shopping center property foreclosed. This foreclosure took place after the judge issued her tentative decision but before it was entered as a final judgment.

Thus, at the time the judgment was actually entered, the landlord, a corporate entity whose only asset had been this shopping center, now owned nothing; it had no assets. The individual owner of the landlord who had a judgment against her for attorneys’ fees allegedly had dismissed her cross-complaint prior to the entry of judgment such that the award of attorneys’ fees was erroneous in her view.

The parties appear for mediation. The tenant has a $750,000 judgment and claims that the landlord does have other assets that it has conveyed to others to avoid creditors from reaching them. The landlord claims it has no assets and nothing has been conveyed to avoid creditors. The individual owner claims the award of attorney fees is in error as she was not a party to the lawsuit at the time the judgment was actually entered. That is, non- parties cannot be held liable.

Applying the grid above to this scenario, it became readily apparent that the matter would not settle. According to statistics issued by the California Judicial Council, for fiscal year ending June 30, 2013, approximately 79% of all appeals are affirmed in whole or in part. Thus, the tenant has an approximate 79% chance of winning on appeal, meaning it also had a 21% chance of losing. To avoid this possible loss, it was willing to settle for a sum that was less than the amount of its judgment. It was “risk averse.” The tenant came to the mediation wanting to settle and willing to accept a sum less than its judgment.

On the other hand, the Landlord had a 79% chance of losing the appeal and thus a 21% chance of winning the appeal. Choosing between these two bad options, it was “risk seeking”. While its chances of winning the appeal were far less than losing it, in reality, it had nothing to lose and everything to gain by not settling and going forward. Thus, the landlord was not willing to settle in any meaningful sense. The mediation did not last long and the parties parted ways to continue on with the appeal.

Perhaps after the appeal is determined and that outcome is viewed in light of the new probabilities of “risk aversion” and “risk seeking” will the parties revisit discussing settlement. But, for now, and probability totally unconsciously, they will stay true to prospect theory.

… Just something to think about!

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