X

Sign up for Equitymaster's free daily newsletter, The 5 Minute WrapUp and get access to our latest Multibagger guide (2017 Edition) on picking money-making stocks.

This is an entirely free service. No payments are to be made.


Download Now Subscribe to our free daily e-letter, The 5 Minute WrapUp and get this complimentary report.
We hate spam as much as you do. Check out our Privacy Policy and Terms Of Use.
Prospect Theory: Relevance for investors - Views on News from Equitymaster
 
 
  • PRINT
  • E-MAIL
  • FEEDBACK
  • A  A  A
  • Sep 15, 2009

    Prospect Theory: Relevance for investors

    "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

    How to Ride Alongside India's Best Fund Managers (The 5 Minute Wrapup)

    Jun 10, 2017

    Forty Indian investing gurus, as worthy of imitation as the legendary Peter Lynch, can help you get rich in the stock market.

    Will They Haul Off Trump's Statue, Too? (Vivek Kaul's Diary)

    Aug 16, 2017

    All across the country, the old gods become devils. New, gluten-free gods take their places...

    This Company Beat the Business World's 'Three Killer Cs' (The 5 Minute Wrapup)

    Aug 16, 2017

    And what it has in common with beating the stock market too.

    5 Steps To Become Financially Independent (Outside View)

    Aug 16, 2017

    Ensure your financial Independence, and pledge to start the journey towards financial freedom today!

    Let's Hope This Correction Continues (The 5 Minute Wrapup)

    Aug 14, 2017

    Last week's correction is making a number of Super Investor stocks look a lot more attractive...

    More Views on News

    Most Popular

    Demonetisation Barely Made Any Difference to Tax Collections(Vivek Kaul's Diary)

    Aug 7, 2017

    The data tells us quite a different story from the one the government is trying to project.

    Proxy Plays: A Smart Way to Bet on 'Off Limits' Companies(The 5 Minute Wrapup)

    Aug 4, 2017

    The small-cap space is full of small players that are clear proxies to great growth stories and Indian megatrends.

    Should You Invest In Bharat-22 ETF? Know Here...(Outside View)

    Aug 8, 2017

    Bharat-22 is one of the most diverse ETFs offered so far by the Government. Know here if you should invest...

    Signs of Life in the India VIX(Daily Profit Hunter)

    Aug 12, 2017

    The India VIX is up 36% in the last week. Fear has gone up but is still low by historical standards.

    7 Financial Gifts For Your Sister This Raksha Bandhan(Outside View)

    Aug 7, 2017

    Raksha Bandhan signifies the brother-sister bond. Here are 7 thoughtful financial gifts for sisters...

    More
    Copyright © Equitymaster Agora Research Private Limited. All rights reserved.
    Any act of copying, reproducing or distributing this newsletter whether wholly or in part, for any purpose without the permission of Equitymaster is strictly prohibited and shall be deemed to be copyright infringement.

    LEGAL DISCLAIMER: Equitymaster Agora Research Private Limited (hereinafter referred as 'Equitymaster') is an independent equity research Company. Equitymaster is not an Investment Adviser. Information herein should be regarded as a resource only and should be used at one's own risk. This is not an offer to sell or solicitation to buy any securities and Equitymaster will not be liable for any losses incurred or investment(s) made or decisions taken/or not taken based on the information provided herein. Information contained herein does not constitute investment advice or a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual subscribers. Before acting on any recommendation, subscribers should consider whether it is suitable for their particular circumstances and, if necessary, seek an independent professional advice. This is not directed for access or use by anyone in a country, especially, USA or Canada, where such use or access is unlawful or which may subject Equitymaster or its affiliates to any registration or licensing requirement. All content and information is provided on an 'As Is' basis by Equitymaster. Information herein is believed to be reliable but Equitymaster does not warrant its completeness or accuracy and expressly disclaims all warranties and conditions of any kind, whether express or implied. Equitymaster may hold shares in the company/ies discussed herein. As a condition to accessing Equitymaster content and website, you agree to our Terms and Conditions of Use, available here. The performance data quoted represents past performance and does not guarantee future results.

    SEBI (Research Analysts) Regulations 2014, Registration No. INH000000537.

    Equitymaster Agora Research Private Limited. 103, Regent Chambers, Above Status Restaurant, Nariman Point, Mumbai - 400 021. India.
    Telephone: +91-22-61434055. Fax: +91-22-22028550. Email: info@equitymaster.com. Website: www.equitymaster.com. CIN:U74999MH2007PTC175407
     

    Become A Smarter Investor In
    Just 5 Minutes

    Multibagger Stocks Guide 2017
    Get our special report, Multibagger Stocks Guide (2017 Edition) Now!
    We will never sell or rent your email id.
    Please read our Terms

    S&P BSE SENSEX


    Aug 16, 2017 (Close)

    MARKET STATS