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
the street put on your headphones and listen to an audible audiobook you can get two free audiobooks
by going down below i also want to throw up a list of my patrons from patreon no pressure to join
although it does help me if you go and buy me a coffee as always see you guys next time peace you