It is often said that investing is all about judgement but, regrettably, as investors, we are often blissfully unaware of the numerous biases that influence our own judgement. This is a shame because psychological research has made giant strides in the past three decades in understanding how the human mind systematically misjudges the world around us. This is the field known as "behavioural economics". It was largely established as a discipline by Israeli-American psychologist, Daniel Kahnemann, who won the 2002 Nobel Prize in economics for his work on this subject, along with his colleague, the late psychologist Amos Tversky.
The two of them developed "prospect theory" which has inspired much of the subsequent work in the field. Kahnemann has recently published an excellent book summarising his work, "Thinking Fast Slow" (available on Amazon). It is well worth any serious investor perusing, as it distils into 500 relatively easy to read pages a lifetime of research into cognitive errors and how human decision-making can be compromised. There's an excellent New York Review of Books piece discussing it by Freeman Dyson.
Kahnemann's work - and behavioural finance more generally - has implications across all the social sciences, but it is also highly relevant to the field of investing. The biases Kahnemann describes in "Thinking Fast & Slow" tend to crop up in precisely the sorts of situations that are involved in investment decisions. As the Finra Foundation has noted, these biases "occur when information is complex, when decisions involve risk and uncertainty, when people are motivated to see things positively (e.g., “this investment will make me rich!”), and when people feel conflicted between their short-term vs. long-term desires (e.g., spending now vs. saving for later)".
Before we delve into the implication of behavioural finance for investing, let's talk a look first at Prospect Theory....
What is Prospect Theory?
Traditionally, finance and economics have been based on the underlying premise that people are rational - and that, faced with making investment or others decisions under conditions of uncertainty, they will seek to maximising their "expected utility" (i.e. they will compare the gains and losses involved with each choice and picking the best one on a net basis). This is known as "expected utility theory". However, research has repeatedly found that we don't actually process information in anything like this kind of rational way. In 1979,…
