FINANCIAL TOOL
Prospect Theory
Since we’ve hit on the subject of gold prospectors, let’s talk about Prospect Theory!
There are two main propositions of Prospect Theory as it applies to finance:
- Investors emotionally feel the pain of loss about 2.5 times greater than they feel the pleasure of an equivalent gain.
- Investors generally underestimate outcomes with a high likelihood, and they overestimate outcomes with a low likelihood.
It’s important for you to know this about psychology, because this weakness is the cause of so much lost wealth due to irrational investor behavior.
Take note: the emotional pain of experiencing a loss is significantly higher than the pleasure of an equivalent gain. So naturally, investors experience fear of loss more intensely than they feel desire for gain.
If Investor A starts with $100,000 and his portfolio falls by 20% to $80,000, he is far more likely to make emotional trading decisions to “stop the bleeding” than if he’d started with $67,000 and grown by about 20% to $80,000.
In fact, even if he experiences a 20% increase, he’s likely to still be worried about loss. So whether he gains or loses, the temptation remains to fear loss.
This results in the observable fact that investors, by and large, underperform markets by buying high and selling low.
Prospect Theory also proposes that investors don’t estimate outcomes properly. For example, a miner in the gold rush era definitely overestimated the chance of acquiring riches. Yet the gold frenzy swept the nation nonetheless. The same goes for gamblers, who by definition overestimate the chance of success.
Then there are those who underestimate the higher likelihood events, such as achieving a high long-term average market return even if they ride through bear markets and take no action at all.
Knowing these tendencies of human nature can help you identify these thoughts and feelings when they arise in your own conscience, and you can more effectively guard against the temptation to act on these irrational biases and misjudgments.