Over the last fifty years, financial theory has developed very dynamically. Academic research has contributed to our understanding of the working of financial markets and investor behavior. One such advancement has been the development of Behavioral Finance, and its role in understanding the market. In this article, we will try to understand a concept that comes under the domain of Behavioral Finance, called the Prospect Theory.
Consumers, as a group, tend to make bizarre choices when it comes to how they carry out their purchases and manage their money. Similarly, investors in financial markets might also make some irrational decisions. It’s almost spooky how an event can trigger so many market participants to react in a similar manner unconsciously.
Behavioral Finance theory attempts to understand this strange behavior. It aims to explain how investors in a market process events and formulate decisions. Behavioral Finance is the study of the influence of basic human psychology on how investors and financial analysts act in the market. The subject focuses on the fact that investors are not always rational, they have limits to their self-control, and are simultaneously affected by their own biases, investors are also people and can make cognitive errors that can lead to wrong decisions. One concept that falls under this domain is the Prospect Theory.
The Prospect Theory, a theory that attempts to explain decision-making under risky circumstances, was first proposed at the end of the 1970s by Daniel Kahneman and Amos Tversky. Basically, it is a psychological theory that describes how people make decisions when presented with choices that involve risk, probability, and uncertainty. One of the aspects of the Prospect Theory is that it challenges the ‘Expected Utility Theory’, which assumes individuals will prefer the outcome which gives maximum utility given the probability of outcomes. But Prospect Theory allows for the fact that people might end up choosing the alternative which doesn’t necessarily maximize utility because there are some other considerations above utility.
When given a choice of equal probability, people would choose to preserve their existing wealth, rather than taking a chance to increase their wealth. The Prospect Theory assumes that as individuals we make decisions based on expectations of loss or gain from their current relative position. An important aspect of this theory is the idea that people are particularly averse to losing what they already own and less concerned to gain. According to Kahneman and Tversky, gains and losses are not valued in the same manner, and thus users make their decisions based on perceived gains and losses. For example, most people would prefer winning $50 with some certainty rather than taking a risky bet in which they can toss a coin and either stand a chance to win $100 or nothing.
There are two phases in this model, firstly, in the editing phase, people decide which outcomes they consider equivalent, they set some reference points, simplify and combine probabilities. Secondly, in the evaluation phase, people calculate the utility based on the probability of outcomes, and then they choose the option with a higher utility. Prospect Theory attempts to explain the biases that people use when they make decisions like these: Certainty, Isolation Effect, and Loss Aversion. Let’s discuss each of these to get a better picture.
We tend to overweigh options that are certain and are risk-averse for gains. One would prefer to get an assured, lesser win than take a chance at winning more (while also risking possibly getting nothing). The opposite is also true, while dealing with certain losses, people engage in risk-seeking behavior so that they can avoid a bigger loss. This bias may also explain why people tend to remain loyal to a specific product, or a service. We can either risk using something else that has the possibility of being a better alternative or we can keep on using our tried and true tool.
It refers to people’s inclination to disregard any elements that are common to both options, instead they try to simplify and focus on what differs. When we remember all the specifics about each individual option, it creates too much of a cognitive load, thus, it only makes sense to remember the differentiators. Discarding common specifics reduces the burden of comparing the choices, but can also lead to inconsistent choices depending on how the options are presented.
Let’s look at two cases, scenario one: You start with $1000 and then asked to choose between, (A) winning $1000 with a 50% probability (or not winning anything), or (B) getting another $500 for sure. In scenario two: You start with $2000, and then asked to choose between, (C) losing $1000 with 50% probability (or not losing anything), or (D) losing $500 for sure. Now, most people make opposite choices in the two scenarios when asked this question, the majority chose the risk-averse option (B) in scenario one, and the loss-averse option (C) in scenario two.
Most of us act in a way that minimizes our losses because losses loom larger than gains, even though the probability of us facing those losses is small. For example, while gambling, winning $100, and then losing $80 feels like a net loss, even though you’ve actually made $20. Speaking psychologically, the pain of losing something is almost twice as powerful as the pleasure of gaining. Why do we hold onto things in our closet that we aren’t wearing? Or, why do we pay for gym memberships that we aren’t using?
We place a higher value on something that we own than on an identical good that we do not own. Investors put their money into assets so that they can earn more money. However, the fear of losing their money seems to predominate in their mind once they’ve invested.
Here are some examples of loss aversion, investors often hold on to an asset just out of pride, even when that asset continues to decline in value, they refuse to admit that they have made an error in judgment, and hold on to it, hoping they can get their money back. This usually doesn’t happen, and they end up facing even greater losses. Investors also tend to invest in low return, guaranteed investments over more promising options that carry higher risk. Another example of loss aversion is selling a stock that has gone up slightly in price just for gain, even if it’s small. Investors also practice this even when your analysis indicates that the stock should be held longer to realize a greater profit.
In conclusion, the Prospect Theory explains some biases that people resort to while making decisions, and that investors are also people, and they’re not always rational. So, there stems a need for us to invest by preparing, planning, and by making sure we pre-commit, and this is what Behavioral Finance attempts to teach us.