Prospect Theory And Loss Aversion PDF

BEHAVIORAL FINANCE CHAPTER IV PROSPECT THEORY AND LOSS AVERSION INTRODUCTION TO PROSPECT THEORY Prospect theory is a concept in behavioral economics that explains how people make decisions when faced with uncertainty, esp...

BEHAVIORAL FINANCE CHAPTER IV PROSPECT THEORY AND LOSS AVERSION INTRODUCTION TO PROSPECT THEORY Prospect theory is a concept in behavioral economics that explains how people make decisions when faced with uncertainty, especially when the outcomes involve risks. Developed by Daniel Kahneman and Amos Tversky, it challenges the traditional belief that people always act rationally to maximize their gains or utility. Instead, prospect theory shows that people often make irrational decisions due to psychological factors, such as how they perceive potential gains and losses. A key idea in prospect theory is “loss aversion”, which means people are generally more sensitive to losses than they are to gains. For example, the pain of losing P 1000. 00 feels much worse than the joy of gaining P 1000. 00, even though the amounts are the same. This causes people to act more cautiously when they think there’s a chance, they might lose something, even if the potential gain is greater. In addition, prospect theory explains that people tend to evaluate risks and rewards relative to a certain reference point, which is often their current situation. If an outcome is seen as a gain compared to this reference point, people are less likely to take risks. But if an outcome is seen as a loss, they may become more willing to take risks in an attempt to avoid or recover from the loss. This theory helps explain many behaviors in areas like investing, where people might make choices based more on emotion than logic. Rather than focusing purely on maximizing returns, people are often driven by the fear of losing money, which can lead to conservative or overly risky decisions depending on the circumstances. LOSS AVERSION AND ITS IMPACT ON INVESTMENT DECISIONS “Loss aversion” is a psychological principle that suggests people experience the pain of losing something more intensely than the pleasure of gaining something of equal value. In other words, losses hurt more than gains feel good. This idea, introduced in “prospect theory”, helps explain why people often make decisions that prioritize avoiding losses over acquiring gains, even when the potential rewards outweigh the risks. Loss aversion can manifest in several different ways, each impacting decision-making in various contexts. Here are some notable types:  Prospect Theory Loss Aversion: This is the most basic form of loss aversion, where individuals fear losses more than they value equivalent gains. In investing, this can lead to overly cautious behavior, such as avoiding risky but potentially high-reward 1  BEHAVIORAL FINANCE investments. Investors may also hold onto losing assets for too long in the hope of avoiding a realized loss, rather than selling and reinvesting in more promising opportunities.  Endowment Effect: Investors place a higher value on assets they already own simply because they own them. This can lead to an emotional attachment to underperforming investments, where investors are reluctant to sell, even when it's clear that the asset has lost value or better opportunities exist. For example, an investor might refuse to sell a stock that has dropped in value, overvaluing it due to ownership.  Status Quo Bias: This type of loss aversion refers to the preference for things to remain the same rather than change. People may resist making changes to their habits or investments because they fear the potential losses associated with change, even if the change could lead to better outcomes. For instance, an investor might stick with a low- performing stock rather than reallocating their funds to potentially better-performing assets.  Sunk Cost Fallacy: This is when individuals continue investing time, money, or effort into a project or decision because of the resources already invested, even if continuing is not the best option. The fear of losing the initial investment drives this behavior, leading people to persist with failing projects rather than cutting their losses and moving on.  Regret Aversion: This occurs when individuals avoid making decisions due to the fear of potential regret. People may stick with a suboptimal choice to avoid the possibility of regretting a decision that could lead to losses, even if the alternative might be more beneficial.  Loss Aversion in Risk-Taking/Gambling: When investors experience losses, they may take on excessive risk to try and recover those losses, such as doubling down on risky stocks or speculative assets. This desire to avoid realizing a permanent loss often leads to riskier behavior, which can increase the potential for even greater financial setbacks. In the world of investing, loss aversion significantly affects how people make decisions. Here are some of its key impacts: 1. Holding onto Losing Investments: Investors often find it difficult to sell assets that are losing value. This is known as the “disposition effect”. Because of loss aversion, they may prefer to "wait it out" in the hope that the investment will recover, rather than accepting a loss and moving on to better opportunities. As a result, they end up holding underperforming stocks for too long, which can damage their overall portfolio performance. 2. Winners Too Early: On the flip side, investors may sell assets that are gaining value too soon. This is because they want to lock in profits and avoid the possibility of those 2  BEHAVIORAL FINANCE gains turning into losses. However, this behavior can limit the potential for further profits, as investors might exit from an appreciating stock prematurely due to fear of losing their gains. 3. Avoiding Riskier, High-Return Investments: Loss aversion can also make investors shy away from riskier investments, even when the potential returns are substantial. For example, they may prefer to keep their money in low-yield savings accounts or bonds rather than investing in higher-return stocks, simply because they fear the possibility of losing money, even if the probability of loss is relatively low. This conservative approach can lead to lower long-term returns and missed opportunities for growth. 4. Overreaction to Market Fluctuations: Loss aversion can cause investors to overreact to short-term market volatility. When the market dips, loss-averse investors may panic and sell off assets to avoid further losses, even if the downturn is temporary. This behavior often leads to selling low and buying high—exactly the opposite of a sound investment strategy. In summary, loss aversion makes people overly focused on avoiding losses, which can lead to poor investment decisions, such as holding onto losing stocks, selling winners too early, avoiding high-return opportunities, and overreacting to short-term market changes. To improve investment outcomes, it’s essential to recognize these tendencies and develop strategies to counteract them, such as focusing on long-term goals, diversifying portfolios, and making decisions based on logic rather than emotion. TWO RELATED BIASES THAT STEM FROM LOSS AVERSION ARE THE ENDOWMENT EFFECT AND STATUS QUO BIAS. ENDOWMENT EFFECT The endowment effect occurs when people assign more value to items simply because they own them. For instance, someone might demand a higher price to sell a product they own than they would be willing to pay to buy the same item if they didn’t already own it. In the context of investments, the endowment effect can lead to the reluctance to sell underperforming assets, as individuals overvalue the asset due to their emotional attachment to it. This irrational behavior can lead to inefficient decision-making, where investors hold on to losing investments longer than they should because they place a higher value on them than the market does. STATUS QUO BIAS Status quo bias is the tendency for individuals to prefer things to stay the same, resisting change even when it might be beneficial. In investing, this can manifest as an unwillingness to 3  BEHAVIORAL FINANCE adjust portfolios, even when market conditions or personal financial goals change. People may avoid switching to better-performing assets or rebalancing their portfolios due to the fear of making a mistake or incurring losses from changing their current holdings. The discomfort associated with potential losses makes people cling to the status quo, even when evidence suggests that change would lead to better outcomes. 4