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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.

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