This is part three of a three-part series on risk in online marketplaces. In case you missed it, here’s a link to parts one and two.
Risk-Attitudes
As more people become increasingly dependent on gig-economy platforms for their livelihoods, it has become necessary for marketplaces to understand the outlook and motivations of their sellers. A seller’s risk-attitude is a product of their own innate preferences along with their perception of the risks and rewards associated with the platform. By understanding the risk-preferences of sellers, a marketplace can engineer itself towards the needs of those sellers.
In a previous post, we talked about income insurance, which is just one example of how a platform can solve a problem that sellers experience. If sellers are risk-averse over earnings, they may be willing to pay for insurance, which would lower their average earnings while reducing the variance they experience in earnings. Unfortunately, risk attitudes are not always so clear-cut. Diagnosing risk attitudes and prescribing a solution involves an awareness of a spectrum of motivations and perceptions. Luckily, Nobel Prize winning economists Kahneman and Tversky introduced a tool to help think about risk attitudes.
The Fourfold Pattern of Risk-Attitudes
The fourfold pattern of risk-attitudes (or FFP) is a representation of how people treat risk across low vs high probability events and across losses vs gains. These fourfold patterns can be described as follows:
- Fear of large loss: People are willing to assume a smaller, certain loss in order to avoid a highly-unlikely, large loss.
- Hope of large gain: On the other hand, when choosing between a highly unlikely windfall and a guaranteed smaller payout, people prefer to shoot for the windfall.
- Hope to avoid loss: When faced with a high-probability of a large loss, people will hold onto the slim chance of avoiding that loss and not choose a slightly smaller but guaranteed loss.
- Fear of disappointment: People prefer certain and moderate gains over virtually risk-free and larger gains.
An easy way to remember these four patterns is by using the two-by-two given here:
Building blocks of the four-fold pattern of risk attitudes
To better understand this 2 by 2 matrix, let’s break down the columns, which distinguish between losses and gains, and the rows, which separate low and high probability events:
- Let’s start with the concept of loss aversion, which we briefly mentioned in a previous post. People feel the pain of loss a bit more than the joy of winning, even when considering the same financial magnitudes. This is because people evaluate their happiness on a relative basis rather than absolute terms, a concept referred to as reference dependence. A person’s reference will determine whether a risk-reward decision is thought of as a loss or a gain, represented across the columns of the FFP.
- Second, everyone knows losses hurt and gains feel good. Small gains feel very good but as gains increase, the amount of joy we derive from an additional dollar of gain begins to decrease. While a $1,000 windfall is twice as great as a $500 one, it doesn’t feel twice as good. Prospect theory calls this decreasing marginal sensitivity.
- Lastly, people overestimate the implications of unlikely (or virtually impossible) events and underestimate the implication of highly likely (or almost certain) events. Even though people can have an accurate understanding of very small and very large probabilities, the impact that unlikely events have on their decision making is disproportionately large and the impact that very likely events have is disproportionately small. Prospect theory adds a value function on top of the standard utility function in order to accommodate these curves so let’s call this curviness of value.
FFP in Crowdfunding
Let’s look at an example of 2 marketplaces with similar software features that both cater to risk seekers – Kickstarter and GoFundMe.To take it even further, the dichotomy of Kickstarter and GoFundMe in the social crowdfunding market is a case study of how differences between the participants of two marketplaces can result in a convergence of risk attitudes.
At their core, both platforms allow users to set up a crowdfunding campaign page, promote their campaign on social media platforms like Facebook, and accept payments from donors. However, when we look at how these platforms position themselves we begin to see a difference.
Kickstarter is a marketplace for people to raise money to “help bring creative projects to life”. Creators use Kickstarter to raise money for ventures that might not appeal to traditional fundraising. Creators only receive the money raised from a campaign if self-defined goals are reached. People who use Kickstarter are likely to view the success of their crowdfunding campaign as a low-probability gain event and are risk-seeking.
GoFundMe is a crowdfunding platform that has a much different purpose. GoFundMe allows people to fundraise for life events ranging from celebrations to challenging circumstances. It has become a leader in medical fundraising and raises more than $650 million a year for medical purposes. People who start medical fundraisers are facing high-probability loss events and are risk seeking.
Though these two platforms cater to entirely different groups of people with unique motivations, they share a risk seeking attitude. The difference is that Kickstart creators are hoping for a large gain, in the form of a fully funded business campaign, and GoFundMe fundraisers are hoping to avoid loss. Here is the two-by-two matrix from earlier with Kickstarter and GoFundMe in their respective quadrants:
Of course, it’s not just a matter of positioning. GoFundMe reinforces their differentiation by paying out funds even if a campaign does not meet its goal.
Concluding thoughts
The FFP is a handy reference to help diagnose the risk-related decision-making process and helps break down the motivations for people’s decisions regarding risk-reward tradeoffs. People encounter risk in all manners of decisions in their daily lives. How they approach and think about risk depends on the elements of prospect theory described above: loss aversion, diminishing marginal sensitivity, and curviness of value. Online marketplaces can benefit tremendously by taking the time and effort to understand the risk attitudes of their stakeholders, both the buyers and sellers, that transact on their platform. This is no easy task, as no population is a monolith and motivations change over time.
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I am a finance and strategy analyst with an entrepreneurial background and research experience at the Federal Reserve. I am interested in tech products, network economics, and corporate finance.
I’m a product and strategy professional with 6+ years of experience in consumer technology and strategy consulting. I write about product management, business strategy and my experiences as a young professional in consumer and B2B software.
Great article, as always. Though I’d like to mention that most people seem to have circumvented Kickstarter’s policy around hitting the goal. They just set ridiculously low minimums (perhaps with Kickstarter’s blessing.)
Just look at this one: https://www.kickstarter.com/projects/cinera/cinera-edge-a-5k-oled-hmd-with-dolby-digital-51-headphone/posts/2879664
It’s some kind of personal cinema headset that would retail at $799, and their goal is just $10,000! That’s literally the cost of ~12 units. They were fully funded in 3 minutes it seems!
That said, I do agree that the campaigns on Kickstarter and GoFundMe are very different, Kickstarter is definitely the platform for entrepreneurs. Though I believe that most entrepreneurs are not big risk-takers. Kickstarter is basically a commission-based marketing platform IMO, with a possibility for high gain, but no real risk, except to one’s ego maybe 🙂