Behavioral Finance – Prospect Theory
Monday, November 9th, 2009 by Cass Chappell, CFP®
The last two years have exposed a lifetime of emotions for most investors. Plummeting markets brought fear. Those who held the course were rewarded with a strong, rapid recovery bringing a sense of euphoria and pride with the wise decision not to sell everything and “stick it under the mattress”.
The 1979 Tversky and Kahneman study* illustrates the impact that aversion to loss has on people’s financial decision-making. An experiment:
One group of participants was given $1000 AND asked to choose between:
A. A sure gain of an additional $500
B. A 50% chance to gain an additional $1000 and a 50% chance to gain nothing
A second group was given $2000 AND asked to choose between:
A. A sure loss of $500
B. A 50% chance to lose $1000 and a 50% chance to lose nothing
The results of either choice posed to the two groups are identical: in choice A, both sets of participants end up with $1500 and in choice B, both sets of participants end up with either $2000 or $1000.
Here is where the behavior of humans enters………
· 84% in the first group selected the known gain (option A) rather than risk a loss (option B)
· 69% in the second group chose option B, indicating that they were willing to assume the greater risk of losing $1000 rather than face the certain loss of $500
The key findings of “Prospect Theory” were that:
· Prospective losses bother investors much more than prospective gains please them
· Choices people make are based on their subjective version of the situation, not on an objective reality
* Source: Lightbulb Press, An Advisor’s Guide to Behavioral Finance, 2008
