Prospect theory

Prospect theory suggests that humans are non-rational decision-makers, and that losses carry a greater emotional impact than gains. It also explains a key reason for inertia in investment decision-making.

Prospect theory is an explanation of human decision-making under conditions where the outcome is uncertain. It can be applied to situations ranging from life decisions, such as whether to switch careers or relocate overseas, through to financial choices such as selecting an investment fund or deciding whether to purchase insurance.

Prospect theory was first defined 35 years ago by psychologists Daniel Kahneman and Amos Tversky1, who were subsequently awarded the 2002 Nobel Prize in Economics for their research in the field of behavioural economics. Also known as ‘loss aversion theory’, prospect theory suggests that humans are non-rational decision-makers, and that losses carry a greater emotional impact than gains, even where there is no difference in the end result.

For example, most people experience the pain associated with losing $100 more intensely than the pleasure associated with winning $100. Research indicates that the emotional impact associated with a loss is around twice that associated with a gain, meaning that a $200 prize would be required to entice the average person to enter into a 50:50 wager of losing $100.

When it comes to investing, one way to avoid the common pitfalls associated with prospect theory is to invest in a professionally-managed investment fund. Experienced fund managers typically have a disciplined investment process and so are less susceptible to emotional decisions than investors who hold shares directly.

 

Evolutionary origins

Although prospect theory was defined relatively recently, psychologists believe that the risk aversion associated with the behaviour was developed as an evolutionary survival mechanism. Longevity was maximised by adopting a cautious approach, for example when deciding whether to challenge a neighbouring tribe or expand into unfamiliar territory.

 

Non-rational decision-making

In addition to highlighting the importance of risk-aversion, prospect theory introduces other concepts that help to explain decision-making:

Reference point is the state of affairs (usually the status quo) that possible outcomes are evaluated in relation to. Investors usually compare the respective gain and loss outcomes separately, rather than considering the final absolute result. This explains the widespread use of rebates and short-term bonus offers, as consumers tend to value these ‘extras’ more highly than identical benefits incorporated in the overall offering.

Decision weight refers to the human bias that distorts probability-based decision-making. For example, we tend to overweight the likelihood of small probabilities (hence the popularity of lotteries) and don’t place enough value on medium to high probability events.

 

Impact on investment decisions

The biased decision-making associated with prospect theory has a significant impact on investment decisions; yet most of us are unaware that our judgement is clouded.

Consider the following example. Jane must choose between two possible investment outcomes:

  1. a guaranteed gain of $250
  2. a 25% chance of gaining $1,000 and a 75% chance of gaining nothing

Jane opts for outcome 1 as she prefers the pleasure of a certain gain over the possibility of receiving nothing.

Market conditions alter, and three months later the two possible outcomes confronting Jane are as follows:

  1. a guaranteed loss of $250
  2. a 25% chance of losing $1,000 and a 75% chance of losing nothing

Faced with these alternatives, prospect theory suggests Jane is likely to choose option 2 as she prefers to risk the possibility of a large loss rather than experience the unpleasantness of crystallising a certain loss.

This example illustrates prospect theory’s link to the disposition effect, or the tendency to sell investments that have risen in value, and hold on to investments that have fallen in value. Successful investors are in fact more likely to do the opposite – hold on to appreciating investments while selling their loss‑makers.

Prospect theory also explains a key reason for inertia in investment decision-making. Investors considering a change in investment strategy or a restructure of their stock portfolio are likely to overweight the risks and potential losses associated with the change, and thus opt for the status quo even when the current situation is no longer optimal.

Awareness of prospect theory and its influence on decision making is the first step in avoiding an investment approach clouded by an emotional aversion to losses. However even armed with knowledge of risk-aversion prejudices, investors can struggle to override these ingrained behavioural biases.

A professional investment manager offers a range of products managed according to disciplined investment processes which can help eliminate bias associated with assessment of upside and downside risks.

The disposition effect

The disposition effect

All investors are prone to behaviours and emotions that can lead to poor investment decisions. One of the most common of these is the tendency to sell investments that have risen in value, and hold on to investments that have fallen in value. In 1985 two academics, Shefrin and Statmen, studied this behaviour and coined it the ‘disposition effect’.

The disposition effect quickly destroys value in two ways:

  1. An investor misses out on the returns of a rising asset.
  2. They continue to hold investments that are falling in value.

Of course if an investor sells all the winners and keeps the losers, they eventually end up with a portfolio of losers!

It’s nearly impossible to avoid losses altogether, but it is possible to minimise them. Cutting losses may seem an obvious thing to do, but it’s less common than you might think.

The disposition effect – a case study

It’s January 2012 and David starts the new year by investing $10,000 in casino operator ABC Casino and $10,000 in mining company XYZ Mining.

Six months on, and ABC Casino has performed well, rising by 31%. David is very happy with this return and can’t see the stock rising much further. He sells the stock, earning a $3,100 profit. He is very pleased with his stock-picking ability.

Meanwhile, David’s holding in XYZ Mining has fallen in value by 25% over the six months. He can’t believe his bad luck, but comforts himself that this is only a ‘paper loss’ – because he hasn’t sold the stock yet, he hasn’t realised the loss. David hangs on to the stock because he can’t afford to realise the loss and thinks that one day it will return to what he paid for it.

Fast forward to the end of the 2013, and David still holds XYZ Mining. Because the stock was performing badly, he lost interest and neglected his investment.

Unfortunately, the XYZ Mining share price continued to fall and David’s investment is now worth just $5,035. Even taking into account the profit he made from the sale of ABC Casino, David is faced with a net loss of $1,865. To make matters worse, ABC Casino rose a further 262% after David sold his shares. David is kicking himself for missing out on this return.

In a different scenario, if David had instead sold his XYZ Mining shares and kept his ABC Casino shares, they would now be worth $48,841. Even taking into account the loss he would have realised when selling XYZ Mining, this is a net profit of more than $31,000 on his original $10,000 investment.

This is an illustrative example of what can happen if you sell a winning stock too early and hold on to a losing stock too long. Of course the same principle applies to all investments, whether individual shares or a portfolio of investments.

Exhibit 1: ABC Casino vs XYZ Mining: cut your losses and let your winners run

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Source: Bloomberg.

What went wrong

David fell into a few common traps when managing his investment:

Trying to pick the top

Many investors sell their shares when they think they have reached the maximum price and the only way is down. In this example, David thought that the ABC Casino share price couldn’t rise much more after it rose 31% in six months – a stellar return. However, the future value of a stock is completely unrelated to its purchase price.

Self-attribution bias

Congratulating yourself on your stock-picking ability when stocks go up, and blaming ‘bad luck’ when stocks go down is called ‘self-attribution bias’. Many of us are guilty of it. Self-attribution bias leads to over-confidence in investment abilities and deters investors from seeking professional advice.

Regret

When an investment goes bad, many investors comfort themselves and avoid admitting a mistake by viewing it as only a ‘paper loss’. However a loss on paper is just as important as a realised loss. Investors are often willing to realise gains but unwilling to realise losses. This is the underlying cause of the disposition effect.

Neglect

When stock markets are rising, many investors enjoy watching the value of their investment grow and take a keen interest. When investments go down, the opposite is true. It’s important to always monitor and manage your investments whatever the market conditions.

Opportunity cost

Opportunity cost is the price paid for following one choice at the expense of another. In this case study, David has passed up the opportunity of holding a stock rising in value by continuing to hold XYZ Mining.

Breaking even

After an investment falls in value, many investors plan to hold onto it until it returns to its purchase price, meaning they will break even and erase their mistake. Unfortunately, this may never happen. In the case study above, XYZ Mining will have to rise 100% to return to what David paid for it two years earlier. Many stocks never regain their previous highs.

Avoiding the pitfalls

Many investors sabotage their own investment success without even realising. One of the key ways to avoid this is to recognise and understand behaviours and emotions that can lead to poor investment decisions.

Long-term investing in a professionally-managed fund is a good way to avoid the common pitfalls. Experienced fund managers typically apply more discipline to their investment process and so are less inclined to make emotional decisions than investors who hold shares directly.