Prospect Theory: Relevance for investors - Views on News from Equitymaster

Helping You Build Wealth With Honest Research
Since 1996. Try Now

  • MyStocks

MEMBER'S LOGINX

     
Login Failure
   
     
   
     
 
 
 
(Please do not use this option on a public machine)
 
     
 
 
 
  Sign Up | Forgot Password?  

Prospect Theory: Relevance for investors

Sep 15, 2009

"Wall Street's Math Wizards Forgot a Few Variables" screamed a headline in New York Times this Sunday. It seems that the mathematical models of risk which suggested that all these complex instruments were safe are responsible for the present economic situation. While these models took into account the expected returns and the default risks of the instruments, what they failed to capture was human behavior and it's potential for widespread panic. Now how important is this one variable which the so called wizards missed. Daniel Kahneman the only psychologist to win the Noble prize in economics put forward the Prospect theory in 1979. It describes how people make decisions around economic risk and demonstrates that people often do not interpret risk rationally, at least in economic terms. The theory shows that people are highly risk averse when it comes to potentially increasing their wealth, but risk seeking when dealing with potential economic loss. Moreover, there is a tendency for the average person to look at losses and gains in percentages rather than absolute terms.

In an experiment Kahneman and his partner Amos Tversky found that if a group of people is offered the choice between:

a) A 100% chance of receiving US$ 3000.
b) An 80% chance of receiving US$ 4000, but a 20% chance of receiving nothing.

About 80% of the subjects chose option (a). In other words, when it comes to making money, the average person prefers a guaranteed gain rather than gamble on the possibility of winning a greater amount of money but with a threat of getting nothing.

However, when given a very similar choice:

c) A 100% chance of losing US$ 3000.
d) An 80% chance of losing US$ 4000, but a 20% chance of losing nothing.

Some 92% of the subjects chose option (d). In other words, they would rather risk losing more money with a small chance of not losing anything.

From a logical perspective, of course, this does not make sense. Assuming people are using the same internal mathematics to evaluate the risk in both cases, we should see similar results. But humans are not logical and most people are extremely poor at evaluating risk. This shows also why the same people buy lottery and insurance.

Prospect theory also explains the Disposition effect. This effect demonstrates the tendency of investors to sell shares whose price has increased, while keeping assets that have dropped in value. The reason behind this is that investors are unwilling to recognize losses (which they would be forced to do if they sold assets which had fallen in value), but are more willing to recognize gains.

This also explains why in spite of Warren Buffett showing us the path he followed through his letters to the shareholders of Berkshire Hathaway there is still only one Warren Buffett.

Equitymaster requests your view! Post a comment on "Prospect Theory: Relevance for investors". Click here!

  

More Views on News

ITI Mid-Cap Fund: Investing in Potential Midcap Companies for Growth (Outside View)

Feb 26, 2021

PersonalFN analyses the features of ITI Mid-Cap Fund and explains the potential this fund has to offer to its investors.

NSE Glitch: Why Did the Market Go Up? (Fast Profits Daily)

Feb 26, 2021

In today's video, I'll discuss why thew stock market went up on Wednesday, 24 February 2021, when the NSE had to shut trading due to a technical glitch.

My Personal Checklist for Your Trading Success (Profit Hunter)

Feb 26, 2021

You my personal trading checklist and you will be well on your way to making it big as a trader.

Make Rs 5,000 Per Day Trading the Market (Fast Profits Daily)

Feb 25, 2021

In this video, I'll show you how to get started on the path to daily trading profits.

Refresh Your Investment Portfolio in 2021 to Align with Your Financial Goals (Outside View)

Feb 25, 2021

Timely review of your investment portfolio is the key, to enable stable returns and work towards your envisioned financial goals during various market phases.

More Views on News

Most Popular

10 Rules for Successful Long-Term Investing

A useful rule book for achieving market beating returns over the long-term investments.

It's the Beginning of a New Bull Phase in Smallcaps (Profit Hunter)

Feb 24, 2021

Last time the smallcap index crossed 19k a big correction followed. Here's what makes it different this time.

Intraday Trading for a Living (Fast Profits Daily)

Feb 15, 2021

In this video, I'll cover your queries on intraday trading and also share my view on how to decide stop losses and target prices.

Top 5 Stocks Mutual Funds Bought and Sold in January 2021 (Sector Info)

Feb 16, 2021

A look at what India's top equity mutual funds bought and sold in January 2021.

I Would Recommend this Small-cap Stock Over Tesla (Profit Hunter)

Feb 16, 2021

Do you enjoy reading Tesla and Bitcoin stories? Here's a not so famous small-cap stock to profit from the rise of EVs.

More

India's #1 Trader
Reveals His Secrets

Secret To Increasing Your Trading Profits Today
Get this Special Report,
The Secret to Increasing Your Trading Profits Today, Now!
We will never sell or rent your email id.
Please read our Terms

S&P BSE SENSEX


Feb 26, 2021 (Close)

MARKET STATS