Prospect Theory

Traditional finance assumes the premise that individuals are generally risk-averse, but in reality risk aversion varies greatly among individuals. It also generally speaks to risk as the standard deviation of an investment and states that individuals are concerned with this aspect.

However, through a groundbreaking investigation by two individuals named Daniel Kahneman and Amos Tversky, they posit that individuals are more concerned with the perception of probable loss than risk. This adds a new dimension to decision making behavior by individuals and expands on the risk premise that traditional finance assumes by incorporating the emotional side of an individual.

The theory was investigated by providing groups of individuals with two sets of questions. The first set would frame the expected outcome around a gain while the second set would frame the expected outcome around a loss.

Mathematically, both sets of questions are essentially the same and the choice between each, from a mathematical perspective, should not differ. The primary reason for the different choices is due to how the questions are framed. Let’s look at the classic example:

Scenario 1 – Gain Framed

You have R1000.

Your are offered:

1. A 50% chance to make R1000 and a 50% chance to nothing.

2. A 100% chance to make R500

If you choose option 1 you will end up with either R2000 or R1000. If you choose option 2 you will end up with R1500.

Scenario 2 – Loss Framed

You have R2000.

You are offered:

1. A 50% chance of losing R1000 and a 50% chance of losing nothing.

2. A 100% chance to lose R500.

If you choose option 1 you will end up with either R1000 or R2000. If you choose option 2 you will end up with R1500.

You can see that the two situations are the same mathematically.

When these questions were asked to a group of individuals, they consistently chose option 2 in the first scenario and option 1 in the second scenario.

The reason for this, as described by Kahneman and Tversky, is because individuals are more averse to a certain loss than an uncertain gain. Even though the outcome of all the options are mathematically identical.

This loss aversion can be graphed as follows:

Prospect Theory
Prospect theory provides the basis by which to understand how human emotions influence decision with regards to investing.

For example, since there is evidence that people value gains less than losses (in an absolute sense) it explains why individuals may cut winning positions too soon, or “double down” on losing positions in the hopes of making up the loss. This leads us to the emotional biases individuals may face in their investment decision making process.

Emotional Biases

There is no standard definition for emotional biases and individuals will experience them to varying degrees. Furthermore, they are more difficult to correct compared to cognitive biases because they do not stem from a breakdown in logic. Emotional biases are usually ingrained in an individual due to personal experiences and beliefs.

The general emotional biases experienced by individuals, their description and consequences are as follows:

Bias

Description

Consequence

Loss-aversion

As in the example above, an individual may experience more “pain” with a loss compared to the “pleasure” of a gain.

  • Cut winning positions too early

  • Hold onto losing positions too long

  • Inappropriate diversification and risk exposure

Overconfidence

Evident when an individual inappropriately assumes their decision making process, even themselves, is superior. Closely linked to the Illusion of Control cognitive error.

  • Excessive trading

  • Inappropriate measurement of risk and return

  • Inadequate diversification

Self-control

Evident when individuals respond to short-term changes without keeping long-term goals in mind

  • Inappropriate risk taking

  • Inappropriate diversification

Endowment

When an individual thinks an asset is worth more than it actually is purely because they already own the asset.

  • Missing an appropriate selling opportunity

  • Holding assets which are familiar leading to inadequate diversification

Regret aversion

Evident when individuals do not action a valid sell signal for fear of losing out of further gains, or jumping on the band wagon when an asset is increasing rapidly to be part of the herd.

  • A portfolio that is too conservative or too concentrated in a “flash” asset.

  • Inappropriate diversification in relation to the investment goal.

Status quo

Inaction of legitimate investment signals due to the individual being happy with the way things are.

  • Missed investment opportunities.

  • Inappropriate portfolio risk characteristics.

Now that we have looked at both traditional finance theory and how the investment decision is made in an efficient manner, as well as behavioral finance theory and how it relaxes traditional finance assumptions to cater for real-world individuals.

We move onto the asset allocation process in an attempt to try allocate assets in an efficient manner according to traditional finance, while making allowances for deviations from the efficient allocation according to behavioral finance.

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