How to Use Prospect Theory to Cope with Loss Aversion
I have yet to meet anyone who likes to lose money. Sure, there are those titans of industry who will hang onto a losing enterprise just to offset gains elsewhere. But as humans, we intuitively know that gains feel good, and losses feel bad. But what is behind these feelings? And what if our tendency to feel this way is actually holding us back?
In 1979 two Israeli psychologists, Daniel Kahneman* and Amos Tversky, formulated prospect theory to explain our natural instincts towards loss aversion and our tendency to perceive gain as superior to loss, even when the results are actually the same.
Here’s an example of how this works. Imagine that you are presented with two options for receiving $100. No matter which you choose, the result will be $100 in your pocket. Option one is that you are given the $100 outright. Option two is that you are given $200, but you then have to return $100. Prospect theory says that you are more likely to choose the $100, straight up. This is because humans tend to prefer a single gain over a gain followed by a loss.
What does this have to do with finance and investments? Here’s another example.
You are an investor and your financial advisor is educating you on investments. First, your advisor highlights that the average annual return of one investment over the past 10 years has been 10%. You think, “Not bad. Tell me more.” Then your advisor presents another investment with an average annual return of 10%, but with above average returns for the past seven years and a record of underperformance for the past three. Imagining a loss sends a shiver down your spine, so you choose the first option. Then your advisor reveals that they are actually the same investment. Prospect theory is alive and well.
Realizing that there is a natural human tendency to be averse to loss is one of the first steps to successfully investing for the long run, as there will be times of loss along the road to gains. Couple this with a properly calibrated risk tolerance, realistic goals, and an appropriate time horizon, and you have a high probability of enjoying a positive, fulfilling investment experience.
A good financial advisor can help with all of these.
Written by author: Jarrod Jacobi | Senior Financial Advisor, AWMA®
*The foregoing content reflects the opinions of Van Hulzen Asset Management DBA "Van Hulzen Financial Advisors" and is subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. Past performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful.
*Interesting side note: In 2002, Dr. Kahneman won the Nobel Memorial Prize in Economic Sciences for his work on the psychology of judgment and decision-making. This made him only the second psychologist to win this highest award in economics.