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, in the most cited paper ever to appear in Econometrica, the prestigious academic journal of economics, Kahneman and Tversky presented an alternative idea, known as "prospect theory". Also called "loss-aversion theory", the model is descriptive rather than being normative (i.e. telling people how they should behave). Thus, it tries to model real-life choices humans make, rather than focusing on how they should make optimal decisions. A vast amount of experimental data supports the idea that prospect theory is a much more realistic view of human decision-making.
There are four main ideas that are central to prospect theory. These are i) framing, ii) loss aversion, iii the reflection effect, and iv) decision-weights.
Reference Point / Framing
A key observation of prospect theory is that people tend to think of possible outcomes usually relative to a certain reference point (often the status quo), i.e. gains and losses, rather than focusing on the final status, a phenomenon which is called the "framing effect". In contrast, traditional economics assumes that individuals only care about absolute levels of, say, wealth, not relative wealth let alone changes in wealth - i.e. a rational agent should be indifferent to a reference point. This framing effect introduces irrationality - it is possible to change someone's decision simply by changing the frame of reference.
Loss aversion refers to the fact that people actually value gains and losses differently. Losses have more emotional impact than an equivalent amount of gains and are therefore weighed more heavily in our decision-making. In a classic study, researchers found that, if you have a mug and you are forced to sell it, the dis-utility is a lot higher than the utility if you didn’t have one and someone gave it to you. Likewise, in investing, someone who loses £1000 seems to feel worse than the satisfaction gained by someone who receives a £1000 profit. Some studies suggest that losses are twice as powerful, psychologically, as gains. This effect can be seen in marketing where the widespread use of trial periods and rebates takes advantage of the buyer's tendency to value something more after he/she incorporates it in the status quo.
Traditional economics assume that people are risk-averse in all of their choices, i.e. they are not willing to accept risk without compensation. In prospect theory, the idea is that people are risk-averse in regards to gains but they are risk-seeking in regards to losses, because people detest losses much more than they appreciate gains. Consider the following example:
A) You are guaranteed to gain £24,000
B) You have a 25 percent chance of gaining £100,000 and a 75 percent of gaining nothing
In this situation, most people choose A because they do not want to take a risk of gaining nothing. However, when the situation involves losing £24,000 for sure versus having a 25% chance of losing nothing and a 75% chance of losing £100,000, people are overwhelmingly likely to take the risk of losing £100,000.
This phenomenon can be observed with investing. When making money on a trade, people often take the guaranteed option by taking profits and locking in that ‘guaranteed’ gain. However, when losing money on a trade (a loss), most people choose to take the risky option by running losses and holding the stock. In contrast, good investors usually do the exact opposite… they cut their losses and run their profits!
Prospect theory also differs from traditional economics in the way it handles the probabilities attached to particular outcomes. Classical utility theory assumes that decision makers value a 50% chance of winning as exactly that: a 50% chance of winning. In contrast, prospect theory treats preferences as a function of “decision weights” which do not always correspond to probabilities. Specifically, prospect theory postulates that human beings tend to overweight small probabilities and underreact to moderate and high probabilities. This explains people's demand for lotteries offering a small chance of a large gain, and for insurance, protecting against a small chance of a large loss. In the book, Kahnemann suggests the estimated weightings are typically use to evaluate a range of probable gains. Neuroscientists have apparently confirmed these observations, by finding regions of the brain that respond to changes in the probability of winning a prize.
As Kahnemann notes:
"You can see that the decision weights are identical to the corresponding probabilities at the extremes: both equal to 0 when the outcome is impossible, and both equal to 100 when the outcome is a sure thing. However, decision weights depart sharply from probabilities near these points. At the low end, we find the possibility effect: unlikely events are considerably overweighted. For example, the decision weight that corresponds to a 2% chance is 8.1. If people conformed to the axioms of rational choice, the decision weight would be 2—so the rare event is overweighted by a factor of 4. The certainty effect at the other end of the probability scale is even more striking. A 2% risk of not winning the prize reduces the utility of the gamble by 13%, from 100 to 87.1.
The implications of such a theory for investing are vast, and we'll be discussing them further in subsequent articles.