Which option would you pick?
Let’s say you needed surgery, and your doctor asked you to decide between two options; one procedure has a 75% chance of survival, while the other has a 25% chance of resulting in death.
Most people will pick the first procedure, even though the outcome between both surgeries is the same.
Why?
Although there’s no difference between surviving or dying in both scenarios, Prospect Theory says that most people will usually choose the option that will give them a perceived better outcome or a higher rate of return.
What is Prospect Theory?
Prospect theory is a decision-making model that defines the way people choose between probabilistic alternatives that involve risk, where the probabilities of outcomes are unknown.
Gary Becker published his paper on Prospect Theory in 1976, and it became one of the seminal papers in modern economics. He argued that humans are not rational beings when faced with risky decisions.[1]
For instance, instead of weighing two options against each other rationally (to make an optimal choice), our brains tend to favor one option over another – all because of visual messages, word associations, or the way the options are presented or framed.
How Does Prospect Theory Affect Investing?
Prospect theory is a decision-making process that affects how people invest, and it plays a major part in the way investors are influenced by how they see a future outcome.
For example, when deciding whether or not to buy a certain stock, the risk of losing money on that trade looms larger in the mind than the possibility of making money on it. This means that some investors tend to avoid risky investments for fear of losing a little bit of capital instead of taking risks in order to make more money. In short, prospect theory says that investors will choose to invest in a product if it offers them more perceived gains, but sometimes perception isn’t reality.
The detrimental effect of having the prospect theory mindset for investors is some people make financial decisions based on the perception on how likely something is to happen instead of rationally thinking of its potential loss or reward.
What is Loss Aversion?
Prospect theory does not take into account the emotional response someone will have when they face losses. Loss aversion, on the other hand, takes into consideration emotions, and attaches more importance to the fear of losing than the expected pleasure from making an equivalent gain in the market.
Psychologist Daniel Kahneman developed the Loss Aversion Theory, and in 2002 won the Nobel Prize in Economic Sciences for his study and contributions to behavioral economics.[2]
This type of behavior is why some investors may hold onto losing stocks longer because they want to regain their losses, while on the other hand, sell winning stocks quickly after making smaller profits.
Some people believe that we humans are hardwired to be loss-averse due to evolutionary pressure on losses and gains. For example, for an early human who is living close to the edge of survival, losing a day’s amount of food could mean death, whereas gaining an extra day of food would not necessarily increase an extra day of lifespan. In other words, people value goods they possess over identical goods that they don’t own.
Even if cutting your losses on a stock earlier would have been more profitable in the end when combined with the gains of a winning stock, some people will become disappointed with their gains because of the remorse of having lost money in the first place. Unfortunately, this kind of behavior can lead to making riskier trades over time.
The takeaway: Prospect theory is the decision-making model that assumes some people are irrational when faced with a choice. Loss aversion means that often times people will work harder to avoid losses than they will to achieve gains – even if the amounts are the same.
How Can Riskalyze Help?
The stock market is a scary place for many people, but that could be lack of understanding – and that’s ok – it’s one of the reasons why independent financial advisors exist in the first place.
Investing on your own can be intimidating and stressful. It seems like everywhere you turn there is a different opinion on what stocks to invest in, which funds are the best, and when to sell.
Riskalyze is a tool that financial planners and wealth managers use to help their clients avoid psychological traps by adopting a strategic asset allocation strategy, which potentially allows for thinking rationally, and not letting emotion get the better of them.
Riskalyze provides tools for analyzing investment risk and invented the “Risk Number” which assists in measuring investor risk tolerance and portfolio risk.
Risk Alignment
Riskalyze helps wealth advisors create an investment plan based on your personal risk score. With the help of an independent financial advisor, you can see how much you could invest in each asset class, draw conclusions about your risk tolerance with an easy survey that takes just seconds to complete.
Want to see your Risk Number?
Riskalyze can help you build an asset allocation strategy, help you to think rationally about your risk tolerance, and potentially not let emotion get the best of you.
Your Emotions vs. Your Investments
Apart from loss aversion, there are several reasons why investors make less than perfect financial decisions based on their emotions. One reason is the tendency to underestimate the risks associated with investments. Another reason is that during periods of market volatility, investors often impatiently move funds from higher risk securities to lower risk investments which could potentially involve a loss.
Dollar-cost averaging (DCA) and diversification are two approaches that investors can implement to make consistent decisions that are not driven by emotion. Staying the course through volatility in the short term can be helpful to the success as an investor in the long term as history has shown, but of course, as we all know, nothing is guaranteed.
Having an independent financial advisor can be an important part of financial planning. It can be helpful to have someone to talk with about financial goals, investments, and the economy as a whole. A financial advisor can help you set financial goals and develop a financial plan for pursuing those goals.
Instead of relying on emotions, professional wealth planners can take into account your financial situation, including things like your financial needs, financial risk tolerance, and investment preferences.
In Conclusion
Investing is a complicated endeavor with lots of risks involved, which is why loss aversion has become such an important aspect of investing psychology. Loss aversion can make some people feel like losing money is twice as bad as making money, but loss aversion doesn’t have to be part of your investing decisions.
You can strive to make better choices for yourself if you know more about loss aversion and how it operates by using tools such as Riskalyze to help determine your risk tolerance.
Asset allocation does not ensure a profit or protect against a loss. Dollar cost averaging involves continuous investment in securities regardless of fluctuation in price levels of such securities.
An investor should consider their ability to continue purchasing through fluctuating price levels. Such a plan does not assure a profit and does not protect against loss in declining markets.
All investing involves risk including loss of principal. No strategy assures success or protects against loss. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
[1] Becker, Gary S. 1976. “The Economic Approach to Human Behavior.” In The Economic Approach to
Human Behavior. Chicago: University of Chicago Press. Pp. 3-14.
[2] https://www.nobelprize.org/prizes/economic-sciences/2002/summary/ (Retrieved 09/28/2021)
