A Closer Look at Prospect Theory, Loss Aversion, and Recency Bias
For the 30-year period ending December 31, 2019, the average equity fund investor earned a 5.04% annual rate of return. During that same interval, the S&P 500® index returned 9.96% annually.1 How is it that investors could so dramatically underperform the market? Fees and expenses can explain some of this difference. But to genuinely understand the root cause, we need to look elsewhere—to what makes us tick as investors who sometimes let emotions overtake logic when we make decisions.
Rooted in the groundbreaking late 70s behavioral psychology work of Nobel Laureate Daniel Kahneman and Amos Tversky, the field of behavioral finance was born2. Its mission is both simple and fascinating:
To explain and better understand the reactions and reasoning patterns of investors (including the emotional processes involved), and the degree to which they influence decision-making. 2
In other words, why do we sometimes do the wrong things at the wrong time with our money? What are the psychological biases that influence our financial decisions and may lead us to ill-advised and/or ill-timed actions?
Investors can overestimate the likelihood of a ‘tail event’ happening (e.g., a low-probability, high-impact positive or negative outcome)—often based on no credible information, just a hunch. 2 Yet despite the very remote chance that one of these outlier events will occur, we may tend to chase the positive and fear the negative. Not only will we potentially pay a premium in hopes of the former, we may demand an even higher ‘risk premium’ to face the latter.
It's the reason why many of us may gladly pay $1 for a one-in-a-million chance to win $1 million, but would demand a far greater risk premium than $1 if the tables were turned and we faced a one-in-a-million chance of losing $1 million. And it may help to explain why some stock market investors may demand a risk premium—an excess prospective return—to own equities versus other assets such as bonds or cash equivalents.
This is the corollary to prospect theory—explaining why, when faced with the possibility of losing money, long-term investors may take on even more risk by getting out of the stock market and moving into cash. Even though they may know that historically, stock returns have far outpaced other investment classes (with bonds and cash barely staying ahead of inflation), but when periods of market volatility hit, the fear of losses may cause many otherwise level-headed investors to flounder. 2
This thinking not only may lead to substantial opportunity cost in the way of missed opportunities, it can also change the overall portfolio asset allocation that an investor is following, and reduce diversification (taking on unnecessary risk) as investors abandon certain asset classes. 2
Did you know?
The pain of losing has been measured psychologically to be twice that of the pleasure associated with a gain!2
Similarly, despite the potential advantages associated with tax loss harvesting (realizing losses to offset capital gains), many investors seem incredibly reluctant to sell stocks which have incurred a loss—choosing instead to hold on in hopes of a turn-around and opting instead to sell their ‘winners.’ 2
You may have said to yourself, “I’ll sell that stock as soon as it gets back to breakeven?” Deep down you may know that any decisions about buying, selling, or holding onto a certain stock should be based solely on the merits of the company’s long-term prospects and its suitability as a holding within your portfolio. But letting go can be hard.
Investors impacted by this behavioral tendency favor most recent events over historic ones. They are often convinced a move in a security price, or the stock/bond market, that has occurred in the near past, might continue on its current path, up or down. These investors should consider the possibility a change in direction could occur, catalyzed by almost anything.
How can one avoid the mistake of “buying high and selling low?” Reverting back to the financial plan that spells out the long-term objectives and what is necessary to achieve financial success helps to pull the lens back from the moment.
Overcoming These Biases
Try to stay focused on long-term goals as outlined in your financial plan instead of short-term market movements. Avoid becoming over-saturated with financial news (yes…that means turn off the news) which can serve to fuel emotionally driven decisions. And maintain a steady ongoing dialog with your Janney Financial Advisor. He or she can help address your concerns, frame possible actions in a way that allows you to remove emotion from the equation, and keep you focused on long-term goals rather than short-term distractions.
Biases aren’t always a bad thing—sometimes (as with ‘risk aversion’) they’re hard-wired into our DNA from evolutionary self-preservation. But the better we understand how these biases can slant our perceptions and influence our actions, the easier it may become to avoid their excesses and keep our financial plans on track.
1 “Quantitative Analysis of Investor Behavior,” DALBAR, 2020
2 Daniel Kahneman and Amos Tversky, "Prospect Theory: An Analysis of Decision under Risk," Econometrica, (1979).
Janney Montgomery Scott LLC, its affiliates, and its employees are not in the business of providing tax, regulatory, accounting, or legal advice. These materials and any tax-related statements are not intended or written to be used, and cannot be used or relied upon, by any taxpayer for the purpose of avoiding tax penalties. Any such taxpayer should seek advice based on the taxpayer’s particular circumstances from an independent tax advisor.