Investors willing to pay for predictability: study

A new study conducted by a pair of Canadian business professors using the British version of the popular game show Deal or No Deal has found people have a tendency to sacrifice profit for predictability.

In the game show Deal or No Deal, hosted in North America by Howie Mandel, contestants randomly pick a briefcase, and then select other briefcases with dollar amounts between a penny and $1 million. As the subsequent briefcases are eliminated, the amount contained is removed from a list of possible prizes. As the list dwindles, the player is given a better sense of what the initial briefcase is likely to be hold.

Intermittently, a “banker” will call the contestant, offering to buy the case based on the numbers left on the board. The banker tries to buy the briefcase for less than its statistical probable worth, while the contestant is hoping to sell the briefcase for more than its likely worth.

There’s only slightly more strategy in controlling the outcome in the game than there is playing roulette, but, as in roulette, the contestant can choose when to exit the game.

Eric Dolansky, assistant professor of marketing at Brock University, is co-authoring a study with Mark Vandenbosch, a professor at the Ivey Business School at the University of Western Ontario, that examines when contestants choose to take the deal and walk away.

Using the British version of the game — which has had a longer run than its American counterpart, Dolansky has compiled a database of the decisions made by over 900 contestants, to determine how price perception sequencing affects their decision to exit the game.

In aggregate, he found that the greater the variability of offers from the banker, the more likely a contestant is to exit the game. He says contestants are clearly more comfortable playing the game if there is a predictable trend in the banker offers, even though statistically the odds of outcome might not be all that different.

“Even with two contrasting examples where somebody picks all high numbers or low numbers at the beginning, if there is some sort of trend they can perceive over time, they are more likely to stay in the game,” Dolansky says. “A person who has banking offers bouncing all over the place is less likely to stay in the game.”

Dolansky points out that their findings are very much in line with the findings of researchers in other fields: consumers as a group do not like variability.

“The impetus of this project was as a way to investigate variable pricing. A lot of companies use variable pricing. We’re not really certain about how consumers perceive the variability of prices. We know from other arenas that consumers tend not to like variability. What we found in the price sequence research is that there are really two types of variability. There is mathematical variability, expressed as variance, and there is perceived variability, which correlates to variance but is not the same thing.”

Dolansky says previous studies have found that if you offer consumers the numbers one to 10 in ascending order, versus offering them in random order, people perceive a greatly variability within the randomly presented numbers, even though variance is mathematically identical.

“What we found is that perceived variance matters,” Dolansky says. “To marketing managers, perceived variance can hurt your pricing strategy. From a finance perspective and advising people, people want to avoid variability. People are going to have different risk tolerances, but it’s not just about the different risk tolerances of mathematical variance. You need to be aware about the risks associated with perceived variability.”

The choice of predictability over variability seems like common sense. This research takes on greater significance when you consider that people will pay a premium for predictability, even sacrificing extra profit for predictability. This is why homebuyers tend to choose fixed rates over variable rates on mortgages, despite evidence that the latter is historically cheaper. It’s also why contestants on Deal or No Deal will tend to skip out earlier after a high variance in offers, even though, statically, odds tend to improve the longer you stay in the game.

Dolansky believes that, as a group, people will forego potential future gains to avoid risk, uncertainty and variability.

“People are willing to pick an option that is perceived to be less variable, even though they have the same variance and may well cost them more in the long run,” he says. “We see that with mortgage rates — with almost any sort of fixed versus floating situation. For example, over the summer, as gas prices spiked, we saw in the U.S. a surge in gas banks where you buy locked-in gas prices. People who were willing to pay a fee to have a predictable price of gas end up paying more. That’s your standard risk-versus-return stuff as it relates to finance.”

Dolansky suggests that people may be deterred from investing if they can’t wrap their head around their returns.

“Am I going to pick a stock that appears to be more stable over one that appears to be more volatile? And will I be willing to pay a price for that?” he asks. “I’m not a behavioral finance expert, but we’ve learned from Deal or No Deal that as things become more volatile people may remove themselves from the game. If you look at what has happened in the markets, with any type of volatility there is going to be the opportunity to make money if you know what you’re doing and pick the right equities. If investors feel they can’t do that, they may remove themselves from the market, much the way they removed themselves from the game.”

How people view their own risk versus somebody else’s may also be different. In the British version of the game show, there is only one contestant per half-hour episode. Any time remaining after a contestant takes a deal no longer has any consequences for the contestant’s decision-making, so contestants have a tendency to employ a more random selection process.

“No individual contestant chooses box 1, box 2 and then box 3, but when you average out all 900-plus contestants, in general they pick the box numbers in ascending order. Again, that could indicate there’s an aspect of the game they have no control over, but they choose to exert control in that arena simply because they can’t anywhere else,” he says. “From an analysis I’m doing right now, I’m finding when the game is still active people pick the box numbers in ascending order. When the game becomes hypothetical, people stop doing it.”

(03/13/09)