Psychology and Investing: Part 2 - Prospect Theory
In Part 2 of this three-part series we'll cover a topic called Prospect Theory. This theory essentially builds on behavioral finance and dives even deeper into the psychology of why people tend not to think as rationally as it would seem regarding choice. Prospect Theory, along with a series of studies that provided evidence of irrational behavior, turned traditional wisdom on its head.
- Prospect Theory background.
- Evidence of irrational behavior.
- Relevance to Investing.
“If Richard Thaler’s concept of mental accounting is one of two pillars upon which the whole of behavioral economics rests, then Prospect Theory is the other.”Â –Â Belsky and Gilovich
Prospect Theory background
Traditionally, expected utility theory has been the descriptive model used to describe decision making under risk or choices that have uncertain outcomes. However, in 1979 two psychologists, Kahneman and Tversky, presented a critique of this theory and developed an alternative model – Prospect Theory. Conventional wisdom, using expected utility theory, stated the net effect of gains and losses involved with each choice are combined by an individual into an overall evaluation as to whether the choice is desirable or not. "Utility" is a term to define the enjoyment one receives from a decision, and expected utility theory argues that people prefer choices that maximize utility. In other words, the value of our choices is dependent on the final outcome, or overall valuation, rather than individual components such as gains or losses.
Prospect Theory, on the other hand, hypothesizes that we don't actually process information that rationally at all. It argues that people value gains and losses much more than the final asset. In fact, Prospect Theory contends that we value each of the components of a final outcome differently as well, basing decisions on perceived gains rather than perceived losses. According to Prospect Theory, losses have more of an emotional impact on us than an equivalent amount of gains. For example, utility gained from receiving $100 should be equivalent to receiving $200 and then losing $100, but it’s not. Most people view receiving $100 more favorably than receiving $200 and losing $100, despite the net utility being $100. And the research seems to back this up.
Evidence of irrational behavior
Following up on their theory that people often make decisions irrationally, Kahneman and Tversky conducted several studies involving people making judgments between two monetary choices that resulted in losses or gains. Two different scenarios were presented to the subjects:
- Scenario 1: You have $1,000 and you must pick one of the following choices:
- Choice A: You have a 50% chance of gaining $1,000 and a 50% chance of gaining $0.
- Choice B: You have a 100% chance of gaining $500.
- Scenario 2: You have $2,000 and you must pick one of the following choices:
- Choice A: You have a 50% chance of losing $1,000 and a 50% chance of losing $0.
- Choice B: You have a 100% chance of losing $500.
“We have an irrational tendency to be less willing to gamble with profits than with losses. This means selling quickly when we earn profits but not selling if we are running losses.”Â – Tvede
I’ll give you a minute to decide which choice you would pick for each scenario. So which one was it? There really isn't one right answer for either scenario, but if you chose option B for both scenarios you would be considered more risk averse than someone choosing A. If all the subjects would have answered both rationally and logically, they would have chosen either A or B for both scenarios. However, the overwhelming majority of subjects in the study chose choice B for scenario 1 and A for scenario 2Â –Â meaning they were willing to settle for reasonable gains but more likely to exhibit much riskier behavior to limit losses. This would seem to prove the hypothesis that losses are weighted more heavily than an equal amount of gains.
Relevance to investing
So we've seen behavioral finance and prospect theory attempt to provide insight into the decision making process and demonstrate the joy of gains is not equivalent to the grief of losses. This type of behavior is actually on display throughout our financial decisions as well. In fact, it's the simple reason why most people are not willing to save their money and investÂ – future gains offer much less joy than the temporary pain of not having the newest items.
Unfortunately, it's also heavily prevalent in an investor's behavior as well, especially selling patterns. Consider the disposition effect, the tendency for investors to hold on to losing stocks for too long and sell winning stocks too soon. If we look back to the subjects in the study we see this effect clearly explained as they were willing to accept reasonable gains but much less willing to take a loss. Determining a fair value range for each of your investments as well as knowing when and why to sell are particularly important. In fact, after this series I'll write an article detailing just that.
“Prospect Theory helps explain how loss aversion, and an inability to ignore sunk costs, leads people to take actions that are not in their best interest. The sting of losing money, for example, often leads investors to pull money out of the stock market unwisely when prices dip.”Â – Belsky and Gilovich
The above quote feels like it would come straight out of Benjamin Graham's "The Intelligent Investor"Â yet it actually comes from a book on behavioral economics titled "Why Smart People Make Big Money Mistakes," the point being behavioral finance and prospect theory offer similar lessons that Graham preached long ago. Approach investing with as little emotion in the game as possible and stick to a businesslike philosophy to elude potential traps and biases. Speaking of traps and biases, I'll discuss how to identify and avoid them in the final part of this series.
- Prospect Theory is an alternative model for describing the decision-making process.
- Contrary to the Expected Utility Theory, Prospect Theory recognizes people do not process information all that rationally when determining a choice.
- Studies reveal we value gains and losses rather than the net outcome, and that losses tend to weigh heavier on us than an equivalent amount of gains.
- When it comes to investing, this type of behavior is seen all the time in the disposition effect, the tendency for investors to hold onto losing stocks for too long and sell winning stocks too soon.
- Utilizing a businesslike approach, determining fair value ranges, as well as knowing when and why to sell can potentially decrease this investing pitfall.
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