Prospect Theory is a concept that explains how people react when faced with gains and losses in the markets. The early research that went into it was done by Amos Tversky and Daniel Kahneman, two prominent social scientists. The latter went on to win the 2002 Nobel Prize in Economics and write the runaway international bestseller ‘Thinking Fast and Slow,’ which deals with human quirks in behaviour and decision-making. The broad subject is referred to as Behavioural Economics (BE).
I find it fascinating that many people who give financial advice are unaware of the BE research or, if they are aware, do nothing to incorporate it into the advice they give. The implications of the old saying that those who ignore the lessons of history are condemned to repeat them are enormous.
Investors are feeling cocky
That’s especially true with Prospect Theory, which is vitally important in the summer of 2021 because markets have been on an absolute tear. The result is that investors are feeling confident and cocky. One might even say that many have let their guard down. When things go up with so few meaningful interruptions and no specific, readily identifiable storm clouds on the horizon, a dangerous kind of comfortable complacency might set in.
Many people I speak with these days seem unconcerned by the recent run-ups. Despite a series of potential danger signals such as inflation, deflation, the Delta Variant, and implications of climate change, they seem unperturbed.
Kahneman and Tversky showed that, for mostly emotional reasons, people put more weight on perceived gains over perceived losses and that, when presented with a choice offering equal probability of outcome (i. e., a gain of $1,000 vs. a loss of $1,000), most will choose the potential gains.
Advisors as Behavioural Coaches
For that reason, Prospect Theory is also known as the loss-aversion theory, and it offers a simple example of the risk associated with Optimism Bias. Simply put, people like to focus on positive outcomes: often to the minimization or exclusion of other possible ends. Continue Reading…
In a previous post on my series on Behaviorial Finance, I reviewed Richard Thaler’s concept of Loss Aversion behaviour. [the Hub version ran here last week.]
The concept states that people will feel more hurt emotionally with a loss than an equivalent gain gives pleasure.
Consequently, we will be more prone to take excessive risks to eliminate that loss.
Thaler also observed this phenomenon in reverse: specifically, in how people behave when they are making successful financial/investment decisions.
Thaler said this behavior gains critical mass in periods that would be described as financial bubbles, in which people are enjoying repetitive excessive gains in their investments. Using the stock market euphoria of the late ’90s as an example, Thaler comments:
“… in the 1990s individual investors were steadily increasing the proportion of their retirement fund contributions towards stocks than bonds, meaning that the portion of their new investments that was allocated to stocks was rising. Part of the reasoning seems to be that they had made so much money in recent years that even if the market fell, they would only lose those newer gains. Of course the fact that some of your money has been made recently should not diminish the sense of loss if that money goes up in smoke. The same thinking that pervaded the views of speculative investors in the boom housing market years later. People who had been flipping properties in Miami, Vegas had a psychological cushion of house money that lured them into thinking that at worst they would be back to where they started. Of course when the market turned down suddenly, those investors who were highly leveraged lost much more than house money. They lost their homes…”
Conventional thinking has been (and I’ve practiced this myself) that when you have gains in a stock you should take some money off the table and sell the equivalent amount you initially invested in and the then hold the profit amount.
Playing with the House’s money
At that point, you are essentially playing with the house’s or in this case the stock market’s money. If we were to lose all that “profit” or house money, we wouldn’t feel we really haven’t lost any money.
However according to Thaler’s observations about Loss Aversion, we will likely take more aggressive, and riskier decisions when the House Money is reduced, which perpetuates the bubble factor. We will either double down on the investment, continue to hold because we feel it is still a high quality investment compared to other investments (Endowment Effect) or engage in other high risk investment opportunities to regain that House Money. During bubble or bull markets periods, it will work for awhile, however at some point that excessive risk will bite back and ultimately that House Money will likely be gone along with part or all of the initial investment they originally put down.
I had a faced a situation that demonstrates this house money behaviour. I had owned a position in NeuLion. It was a very good investment decision, as it was up nearly 90 per cent so I had made a lot of money on paper. Unfortunately, the stock crashed but I was still up 25%. I decided to sell enough stock to cover my initial investment. The remaing stock I had was therefore House Money. At the time I decided to do this because in my mind I could rationalize and live with the fact that I didn’t really lose money even though the stock tanked royally.
The question that I faced was should I buy more stock at the lower price if the fundamentals of company were still strong or sell the remainder of my position if it fell below my loss threshold, which is 20 per cent. Under the Loss Aversion behaviour that Thaler described, I would buy more stock even if the company has experienced a negative game changer moment and is a riskier prospect.
With awareness of these types of behaviours, I decided to not buy additional stock and instead decided to ride the position out to see if the company could turn it around. If it couldn’t and the position fell another 20 per cent, I would sell the remainder of the position.
It’s interesting as normally one of my disciplines I have built up is to sell positions when they cross a minimum return threshold that I am seeking. Normally for me that is in the 20 per cent range but this time, I decided to hold onto the stock for longer, more so for practice as in the past I have realized that I tend to sell shares earlier and in many cases left money on the table. In this example I strayed away from my discipline and while I didn’t lose money, it could have easily gone the other way.
Managing your Greed
Greed ultimately drives this level of behaviour. The theme from this observation is that as much as it’s important to manage your losses, it is equally important to manage your gains, or more plainly, manage your greed. When you make investment decisions, you need to establish a minimum return you are seeking and when you reach that threshold you should re-evaluate the investment to determine if there is still upside or if it makes sense to bank the profit and move on to better opportunities.
Greed gets the better of us in most cases, but again developing a discipline and avoiding the false sense of security that the House Money Effect offers can allow you a greater chance to maximize the profits and benefits of your successful investment decisions.
Aman Raina, MBA is an Investment Coach and founder of Sage Investors, an independent practice specializing in investment coaching and portfolio analysis services. This blog was originally published on his web site and is reproduced here with permission.
In the 20-plus years I have been investing, I have yet to meet or work with anyone who enjoys losing money.
I’ve met people who have lost money (yours truly included) and I can’t say it gives anyone or myself great satisfaction. We spend all of our time trying to make investment decisions that will be successful.
Unfortunately and it’s nobody’s fault, we don’t spend enough time understanding what losses mean and how they can impact our future decision making beyond the tangible reduction in our RRSP or TFSA broker account.
In my previous post, I discussed a concept involving the Endownment Effect that Richard Thaler observed in his book, Misbehaving: The making of behaviorial economics. According to Mr. Thaler, the Endowment Effect feeds into a general discussion on how we behave when it comes to losing and making money. Conventional thinking suggest that because we don’t like losing money that we will tend to take less risk to minimize loss and conversely take more risk when we are making money.
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