People are able to tolerate different levels of risk.

Economists and psychologists use a term called “risk aversion.”

Risk aversion describes a preference for the “safe” choice even if the average outcome of the safe choice is less than the average outcome of a “riskier” choice.

(There’s a less technical way of expressing this idea: A bird in the hand is worth two in the bush.)

This seems irrational. But risk aversion affects virtually everyone. Here’s an example from the Harvard Business Review:

In a global survey 1,500 managers were presenting with the following scenario:

You are considering a $100 million investment that has some chance of returning, in present value, $400 million over three years. It also has some chance of losing the entire investment in the first year. What is the highest chance of loss you would tolerate and still proceed with the investment?

A risk-neutral manager would be willing to accept a 75% chance of loss and a 25% chance of gain; one-quarter of $400 million is $100 million, which is the initial investment, so a 25% chance of gain creates a risk-neutral value of zero.

Most of the surveyed managers, however, demonstrated extreme loss aversion. They were willing to accept only an 18% chance of loss, much lower than the risk-neutral answer of 75%. In fact, only 9% of them were willing to accept a 40% or greater chance of loss.

But there are a couple of assumptions built into this analysis. The big assumptions are: (1) you can afford to lose and (2) we aren’t dealing with a situation where there’s declining marginal utility.

Both of these factors can and usually do play into the decision of whether to settle or try a case.

Insurance companies have thousands of cases. They can amortize risk.

Injured people typically only have one case. They cannot amortize the risk and are naturally more risk adverse.

Also, there’s the idea that the marginal utility of money over a certain figure starts to decline. It’s like if you were thirsty. The first glass of water is worth a lot. The second a little less. The eighth has almost no value.

Money can be the same way. Maybe $500,000 is enough to purchase a home for your family. Would you risk a $500,000 settlement under that scenario for a possible $1,000,000 verdict at trial if the odds were 50-50 that the verdict would be $0 or $1,000,000?

What does the extra money do for you? Maybe nicer countertops, mature landscaping and a better view? Is that upside worth the risk of ending up with nothing?

For most people it’s not. That’s something to think about when you’re deciding whether to take a last, best and final settlement offer.

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