You invest money to grow it but emotions can play a significant role in your decision-making when trying to prevent losing money. Prospect theory is the idea that people value gains and losses differently, even when potential outcomes are the same. The theory holds that people are inherently motivated or driven to avoid losses whenever possible, as losses have a greater emotional impact. This is a big reason why those who struggle with this can benefit from working with a financial advisor who can take the emotions out of investment decisions.
What Is Prospect Theory?
Prospect theory is a behavioral economics theory developed by Daniel Kahneman and Amos Tversky. The theory says that when people are faced with the prospect of choosing between perceived gains and perceived losses, they’re more likely to choose gains, even when either choice would produce the same result.
Why is that? Simply because losses tend to have a greater emotional impact than gains, even when the two are equal. In other words, people want to avoid losses and their associated emotional pain whenever possible.
Prospect theory describes how people view risk and reward and how those views drive their decision-making. In investing, it’s used to understand why people make the decisions they do and why those decisions may sometimes seem irrational or illogical.
How Prospect Theory Works
Prospect theory operates on the assumption that people would always choose to avoid losses, even when all things are equal. It’s another way of describing how people establish their risk tolerance when making financial decisions.
Specifically, prospect theory looks at how people react to situations in which they gain money or lose it. The theory suggests that:
- When emotion affects decisions, investors may be more likely to focus on immediate results rather than longer-term outcomes.
- As wealth increases, investors become less sensitive to losses.
Prospect theory can have applications in a number of financial settings. For example, the theory has been used to explain how people make decisions when gambling money, earning money and spending it. It also plays a part in explaining why investors do the things that they do, even when it doesn’t seem to make sense.
When someone is given a decision, they first look at all possible choices they could make. How those choices are presented to them or framed can influence which one they select. Specifically, that ties into whether the choices are presented in positive or negative terms.
Once someone understands the choices available to them, they then look at the different outcomes that might be associated with each choice. Again, they’re looking at outcomes in the context of potential gains or potential losses. Prospect theory says that people will typically choose the option that helps them to avoid a loss, even if that choice means incurring more risk.
Prospect Theory and Investing
Emotions can be a strong call to action in investing and it can cause people to make decisions without thinking them through. A simple example is the herd mentality that often kicks in when market fears about a particular investor or sector rise. When panic takes over, that can trigger a widespread selloff. Prospect theory attempts to explain these types of decisions.
Here’s another example. Say that you’ve purchased 100 shares of stock, but the stock has been in a steady decline. Selling the stock could minimize losses if the price continues to drop. But instead of doing that, you decide to stay invested in the hopes that the stock will eventually turn around.
Instead, the stock’s price drops further still. When you finally decide to sell, you end up doing so at a 75% loss. Prospect theory would explain that decision by framing it as an attempt to avoid loss as long as possible by holding on to the stock. The end result, however, was a bigger loss.
Prospect theory can also explain why some investors cash out of investments early, even when they’re doing well. If there’s a perceived risk that a stock that’s on a hot streak will suddenly cool, the investor might sell their shares in order to avoid potential losses. In the meantime, they miss out on additional gains as the stock’s price continues to rise.
Understanding Risk Tolerance vs. Risk Capacity
Prospect theory influences your risk tolerance, even if you’re not aware of it. Risk tolerance is a measure of how much risk you’re comfortable taking with your investments. Someone with lower risk tolerance, for example, might concentrate more of their portfolio on investments that are perceived as being safer, such as bonds. Risk capacity, meanwhile, is the level of risk you need to take to reach your investment goals. So why is that important?
When risk tolerance and risk capacity are misaligned, that can result in falling short of your financial goals. So, if you know that you need to keep at least 80% of your portfolio in stocks to reach your target retirement amount, for example, but you feel more comfortable holding 60% in stocks instead, there’s a chance that you won’t see the level of growth that you need.
Prospect theory can influence where you establish your personal risk tolerance level. Understanding the theory can give you insight into why you assess risk the way that you do and how that can influence your investment outcomes.
How to Take the Emotion Out of Investing
Prospect theory links emotional thinking to action. Being able to recognize some of the most common investing biases can help you avoid scenarios where emotion might cloud judgment. In addition to loss aversion, which prospect theory explains, some of the most common biases include:
- Confirmation bias: Confirmation bias happens when people seek out information that confirms what they already believe to be true while ignoring conflicting information.
- Overconfidence bias: Overconfidence simply means that you overestimate your abilities or skills when it comes to making investment decisions.
- Attribution bias: Attribution bias occurs when investors develop a blind spot to external factors that can affect decision-making, choosing to focus instead on their own inherent abilities.
- Herd mentality bias: As mentioned, herd mentality is what causes investors to follow the pack, even when doing so may result in a negative result. That applies to investing but it can also apply to spending when people are driven by the fear of missing out.
- Recency bias: With recency bias, investors tend to focus on trends in the market and what’s happening now versus looking at past history to shape their decisions.
- Hindsight bias: Hindsight is always 20/20 and this bias effectively tricks people into thinking that they knew all along what the outcome would be. That can lead to overconfidence or assumptions that can cloud future decision-making.
How does an investor avoid these biases? Recognizing how they operate is a good starting point. A financial advisor can also offer an unbiased point of view on the market and your portfolio. They can help you to stay on track with your financial plan, rather than being swayed this way or that, depending on how the wind is blowing.
The Bottom Line
Prospect theory is not a new idea, and you don’t need to be a behavioral economist to grasp how it works. Biases like loss aversion or herd mentality can creep in and if left unchecked, they could push your portfolio off track. Learning how to tame emotions, however, can help you to get closer to your investment goals. The other alternative is to hire a professional advisor who can make all of your investment decisions for you.
Financial Planning Tips
- Consider talking to your financial advisor about prospect theory and how to recognize investing biases. If you don’t have a financial advisor yet, finding one doesn’t have to be complicated. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Taking a risk tolerance questionnaire or survey online can give you a starting point for measuring how much risk you’re comfortable with. You might be asked to fill out one of these questionnaires if you’re opening a new brokerage account or investing with a robo-advisor. Keep in mind, however, that risk tolerance can change over time as you move through different life stages.
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