People are (Shockingly) Bad at Valuing Hedges

People often must plan for the worst. They purchase product warranties, insure their homes, and proactively make backup plans. People should be willing to pay more to hedge against bad outcomes that are more likely to happen. Across 14 studies (N = 5,591) we find that decision-makers instead behave as though they almost fully ignore probability information when hedging against bad outcomes. As a result, they dramatically underinvest in hedges they are likely to need, while overinvesting in those that are unlikely to be helpful. This behavior occurs in both abstract settings (e.g. hedging lotteries) and naturalistic ones (e.g. buying warranties or insurance), occurs with fully incentive-compatible decisions, and is robust across a wide range of probabilities and outcomes. We test a variety of possible explanations. Ultimately, we find support for an account in which participants focus almost solely on the bad outcome they are hedging against, while ignoring how likely that bad outcome is to occur. Interestingly, when the same participants invest to make a good outcome better (rather than hedge to make the bad outcome less bad), they were sensitive to probabilities. Leveraging this result, we find that a reframing of hedges which makes them look more like investments can make hedging decisions better calibrated.