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  1. Behavioral Finance: Introduction
  2. Behavioral Finance: Background
  3. Behavioral Finance: Anomalies
  4. Behavioral Finance: Key Concepts - Anchoring
  5. Behavioral Finance: Key Concepts - Mental Accounting
  6. Behavioral Finance: Key Concepts - Confirmation and Hindsight Bias
  7. Behavioral Finance: Key Concepts - Gambler's Fallacy
  8. Behavioral Finance: Key Concepts - Herd Behavior
  9. Behavioral Finance: Key Concepts - Overconfidence
  10. Behavioral Finance: Key Concepts - Overreaction and Availability Bias
  11. Behavioral Finance: Key Concepts - Prospect Theory
  12. Behavioral Finance: Conclusion

By Nathan Reiff

Common sense might suggest that individuals combine the net effect of the gains and the losses associated with any choice in order to make an educated evaluation of whether that choice is desirable. An academic way of viewing this is through the concept of “utility,” often used to describe enjoyment or desirability; it seems logical that we should prefer those decisions which we believe will maximize utility.

On the contrary, though, research has shown that individuals don’t necessarily process information in such a rational way. In 1979, behavioral finance founders Kahneman and Tversky presented a concept called prospect theory. Prospect theory holds that people tend to value gains and losses differently from one another, and, as a result, will base decisions on perceived gains rather than on perceived losses. For that reason, a person faced with two equal choices that are presented differently (one in terms of possible gains and one in terms of possible losses) is likely to choose the one suggesting gains, even if the two choices yield the same end result.

Prospect theory suggests that losses hit us harder. There is a greater emotional impact associated with a loss than with an equivalent gain. As an example, consider how you may react to the following two scenarios: 1) you find $50 lying on the ground, and 2) you lose $50 and then subsequently find $100 lying on the ground. If your reaction to the former scenario is more positive than to the latter, you are experiencing the bias associated with prospect theory.

Evidence for Irrational Behavior

Kahneman and Tversky engaged in a series of studies in their work toward developing prospect theory. Subjects were asked questions involving making judgments between two monetary decisions that involved potential gains and losses. Here is an example of two questions used in the study:

1. You have $1,000 and you must pick one of the following choices:

                 Choice A: You have a 50% chance of gaining $1,000, and a $50 chance of gaining $0.

                 Choice B: You have a 100% chance of gaining $500.

2. You have $2,000 and you must pick one of the following choices:

                 Choice A: You have a 50% chance of losing $1,000, and a 50% chance of losing $0.

                 Choice B: You have a 100% chance of losing $500.

If these questions were to be answered logically, a subject might pick either “A” or “B” in both situations. People who are inclined to choose “B” would be more risk adverse than those who would choose “A”. However, the results of the study showed that a significant majority of people chose “B” for question 1 and “A” for question 2.

The implication of this result is that individuals are willing to settle for a reasonable level of gains (even if they also have a reasonable chance of earning more than those gains), but they are more likely to engage in risk-seeking behaviors in situations in which they can limit their losses. Put differently, losses tend to be weighted more heavily than an equivalent amount of gains.

This line of thinking resulted in the asymmetric value function:


This chart represents the difference in utility (i.e. the amount of pain or joy) that is achieved as a result of a certain amount of gain or loss. This value function is not necessarily accurate for every single person; rather, it represents a general trend. One critical takeaway from this function is that a loss tends to create a greater feeling of pain as compared to the joy created by an equivalent gain. In the case of the chart, the absolute joy felt in finding $50 is significantly less than the absolute pain caused by losing $50.

As a result of this tendency, during a series of multiple gain/loss events, each event is valued individually and then combined in order to create a cumulative feeling. Thus, if you were to find $50 and then lose $50, you’d probably end up feeling more frustrated than you would if you hadn’t found or lost anything. This is because the amount of joy gained from finding the money is outweighed by the amount of pain experienced by losing it, so the net effect is a “loss” of utility.

Financial Relevance

Many illogical financial behaviors can be explained by prospect theory. For example, consider people who refuse to work overtime because they don’t want to pay more taxes. These people would benefit financially from the additional after-tax income, but prospect theory suggests that the benefit they would achieve from earning extra money for additional work does not outweigh the sense of loss they feel when they pay additional taxes.

The disposition effect is the tendency that investors have to hold on to losing stocks for too long and to sell winning stocks too soon. Prospect theory is useful in explaining this phenomenon as well. The logical course of action would be to do the opposite: to hold on to winning stocks in order to further gains, while selling losing stocks in order to prevent additional losses.

The example of investors who sell winning stocks prematurely can be explained by Kahneman and Tversky’s study, in which individuals settled for a lower guaranteed gain of $500 as compared with a riskier option that could either yield a gain of $1,000 or $0. Both subjects in the study and investors who hold winning stocks in the real world are overeager to cash in on the gains that have already been guaranteed. They are unwilling to take a risk to earn larger gains. This is an example of typical risk-averse behavior. (To read more, check out A Look At Exit Strategies and The Importance Of A Profit/Loss Plan.)

On the other hand, though, investors also tend to hold on to losing stocks for too long. Investors tend to be willing to assume a higher level of risk on the chance that they could avoid the negative utility of a potential loss (just like the participants in the study). In reality, though, many losing stocks never recover, and those investors end up incurring greater and greater losses as a result. (To learn more, read The Art Of Selling A Losing Position.)

Avoiding the Disposition Effect

It is possible to reduce the disposition effect, thanks to a concept called hedonic framing. As an example, for situations in which you have a chance of thinking of something as one large gain or as a number of smaller gains (i.e. finding a $100 bill versus finding a $50 bill and then later finding another $50 bill), it’s best to think of the latter option. This will help to maximize the positive utility you experience.

On the other hand, for situations where you could either think of a situation as one large loss or as a number of smaller losses (i.e. losing $100 or losing $50 two times), it’s better to think of the situation as one large loss. This creates less negative utility, because there is a difference in the amount of pain associated with combining the losses and with the amount associated with taking multiple smaller losses.

In a situation you could interpret as either one large gain with a smaller loss or a single smaller gain (i.e. $100 and -$50, or +$50), it’s likely that you’ll achieve more positive utility from the single smaller gain.

Lastly, in situations that could be thought of as a large loss with a smaller gain or as a smaller loss (i.e., -$100 and +55, versus -$45), it may be best to frame the situation as separate losses and gains.

Try these methods of framing your thoughts, and you may find that they help you to experience these situations more positively. Training yourself to reframe situations in this way can also help to avoid the disposition effect.

Behavioral Finance: Conclusion
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