Prospect Theory – The Pain of Market Dips

Prospect Theory – The Pain of Market Dips

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For the last few months, it has not been pleasant to look at your investment and retirement account statements. Some of you might have decided not to open the statements. Others fret: What to do? How to make sense of the myriad of expert explanations you hear and read?

It is especially during periods like this that we as advisors can prove our value to you by keeping you on track and protecting you from making emotional investment decisions. While you might consider yourself a rational “wealth maximizer”, it turns out that most investors actually make irrational financial decisions. This is one major finding that came out of the relatively new field of Behavioral Finance, which combines behavioral psychological theory with finance to try to explain why people make irrational financial decisions. We will share some interesting concepts from this field in the next few blogs.

Below is a powerful illustration from Credit Suisse’s whitepaper on the psychology of investing.

CS_graph1

Hidden in this roller coaster are a variety of preconceptions or biases that lead to irrational decisions. Today’s focus is on prospect theory, a theory about how people make choices between different options. It is characterized by:

Loss aversion: People tend to feel the pain of loss more acutely than they feel the pleasure of gain. So, if the value of your portfolio went up by $1000 and then came down $800, you might be considering this a net loss in terms of satisfaction, even though you came out $200 ahead, because you’ll tend to focus on how much you lost, not on how much you gained.

Certainty: People have a clear preference for certainty and are willing to sacrifice income to achieve more certainty. For example, if option A is a guaranteed win of $500, and option B is an 80 percent chance of winning $700, but a 20 percent chance of winning nothing, people tend to prefer option A even though the expected value of option B is $560.

In other words, people are willing to leave a lot of money on the table to avoid the possibility of losing.

The sting of losing money often leads people to pull money out of the market. However, the next graph shows the risk of being out of the market at the wrong time:

cost-of-market-timing

You might want to think twice before making any drastic (emotional) decisions during times of market turmoil.

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Barbara Lommen

Barbara Lommen is a financial advisor at Colorado Financial Management.

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