Behavioural Finance, Part 2: Prospect Theory and Loss Aversion

Welcome to Part 2 of our Behavioural Finance series. If you missed Part 1, you’ll find our Introduction to Behavioural Finance here.

There’s a tipping point in the birth of all new disciplines when the scientist, the economist, or the psychologist senses they’re on the brink of a big discovery. That moment in behavioural economics arrived with the definition of Prospect Theory.

The publication of Daniel Kahneman and Amos Tversky’s ‘Prospect Theory: An Analysis of Decision Under Risk’ was the point for behavioural economists when the wave broke, the Eureka moment, their equivalent of the day the apple fell on Newton’s head.

Prospect Theory

Since the 18th century, economists had assumed that we made cold, rational, consistent decisions on the basis of what would result in the optimal outcome for us as individuals (called Expected Utility Theory, or EUT). However, Kahneman and Tversky saw that economists were using EUT as both a description of how decisions should be made as well as a description of how they were being made.

As psychologists, this struck them as absurd: they knew all too well that how we should behave and how we do behave can often be very different. In fact, the struggle between the two is pretty much what it means to be human. Kahneman and Tversky set out to understand how humans actually make financial choices, fully aware that they might uncover some irrational findings.

The results of Kahneman and Tversky’s studies showed that people value losses and gains in dramatically different ways, and that we tend to make financial decisions based on the size of potential gains and losses – not on how much money we end up with. This result contradicted the assumption that traditional economic theories had always been based on, and thus Prospect Theory was born. As investors, these findings can have implications for how we manage our investment portfolio.

Loss Aversion

Prior to the birth of Prospect Theory, economists thought that, as cold rationalists, we felt almost as good about a gain of £10 as we felt bad about a loss of £10. Kahneman and Tversky’s studies showed that this often isn’t the case and that we dislike losing money much more than we like gaining the exact same amount. In terms of how we behave as financial beings, the implications are that people are ready to accept (or settle for) a situation when there’s a reasonable level of gain, but will be much more prone to take risks when they think they can limit their losses. This behaviour is called loss aversion.

Professor Brett Kahr provides a more nuanced view of the psychology of losses and gains:

“It’s not as simple as gains are good and losses are bad. Sometimes both gains and losses can be painful. Loss can feel like the most primitive form of deprivation but with gains come a different type of pain. It’s common to feel guilty about a gain – success is a good example of this – and the fear of having to deal with the fact that your achievements have made you more successful than those around you can have a debilitating effect on many people. Also, the fear of losing that promotion you’ve gained, the feeling that somehow you don’t deserve it or feel like a fraud can affect many people.”

Implications for Investors

In our role as financial lifestyle planners, we ask clients to imagine their ideal financial lifestyle scenario. We create plans that can put our clients on the road to achieving this lifestyle, but when it comes time for our clients to take action, we often find that an aversion to some perceived loss is holding them back. The idea of losing their current lifestyle can bring anxiety, even if the switch is to something better.

For example, many people dream of selling their city homes and retiring to the country. However, some people can be prevented from making this leap by the fear of losing out on a bigger payout for the city house if prices continue to rise. It’s common to come up against a situation where clients are hamstrung by their apprehension of a loss that may or may not materialise.

This situation is made more difficult by the fact that financial gains are much easier to define and quantify than are improvements to your quality of life. A really great financial planner will tell you what you need to hear as opposed to what you want to hear. Sometimes that will be to help identify and counter potential threats. At other times, just as importantly, it will be to encourage you, inspire you, and to say, ‘you know what, you’re in great financial shape to do this and I think you should’.

It’s important for us as advisers to adapt to the personality of our clients in these cases, and to build up the necessary trust over time to guide them throughout the journey. We do this by really getting to know and understand the ideal life they seek, and by building their confidence with a plan and a portfolio to get them there. It’s not just about putting the cash in an ISA and moving on, it’s about listening and matching the financial plan to the lifestyle each client wants to create. Having something to work towards reminds us all why we get out of bed every day: to achieve the goal of building our ideal life.

Professor Kahr shares this view on the importance of trust: “Irrational behaviour in the making of financial decisions has its roots in other realms of experience, well beyond those restricted to finance and investment. One’s decision-making will often depend upon one’s pre-existing psychological character structure; for instance, a person might be excessive or impulsive or retentive, and these particular characterological styles will inform how he or she approaches monetary matters. Financial advisers must take the time to build a relationship with people in a collaborative way so that they can better understand the vulnerabilities and idiosyncrasies of each client. This may well be crucial to long-term investment success.”

Questions to Ask Yourself

How strongly do you agree or disagree with the following statements?

• I hold on to investments that I bought for more than their current value in the hope that they rebound.
• I would be frustrated if an investment increased in value after I’d sold it.
• I prefer to sell investments that have gone up since I bought them to those which have gone down.
• I would rather cut my losses and sell a stock than wait to see if it will bounce back.

If you would like some help in planning your ideal financial lifestyle, please feel free to get in touch.

This document is marketing material for a retail audience and does not constitute advice or recommendations. Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amount originally invested.