An article admittedly
from a large fund manager that we just read that we hope you may find interesting.
Behavioural investing series #5
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 Tversky[1],
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.
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:
A) A
guaranteed gain of $250
B) A 25%
chance of gaining $1,000 and a 75% chance of gaining nothing
Jane opts for outcome A 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:
A) A
guaranteed loss of $250
B) 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 B 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 in situations
where 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.
As we studied Statistics to 301 at Uni over 40
years ago this is possibly its best applied
use.
It is a reason
why we who have been in financial services for 30 years DON’T run our own SMSF.
We could
provide you with other reasons such as we
don’t want to be a trustee, the costs of doing so & paying the accountants
& auditors fees, keeping up with the ATO daily rules changes or making such
investment decisions. Let alone winding it up when a partner expires or is tired of all the above.
An analysis of the average SMSF with a large % in
term deposit & a large % in the top 7 Australian companies reinforces this
paper.
Our role is to maximise the probability of you achieving your
financial objectives
Call
today to your financial adviser John
McAuliffe on 07 3848 1088 or email if you
have any questions about prospect theory.
[1] Kahneman, D. and Tversky, A. (1979). Prospect Theory: An analysis of
decisions under risk. Econometrica, 47, 263 – 291.
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