Behavioral finance FAQ / Glossary (Prospect)

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Dates of related message(s) in the
Behavioral-Finance group (*):
Year/month, d: developed / discussed,
i: incidental

images/images/pi-arrig.gif Prospect theory


 

00/10i - 01/10i  - 02/1i,9i
- 03/5i,8i,9i,10i,12i - 04/4i,8i
-
05/9i - 06/1i - 07/09i
+ see behavioral biases, aversion,
loss aversion, disposition effect,
endowment effect + probabilities

I would admit to lose a sock, but only to find a pair.

Replace socks by Euros, Dollars, Pesos or whatever
currency, and the joke becomes serious.

Definition:

The Prospect theory states that we usually value (past or prospective) gains and
losses differently.

People hate to lose. No surprise here! But they hate it so much that they
give much more (negative) value to what they lose than (positive) value
to what they gain.

They feel much more pain when experiencing a loss
than happiness when benefiting from a gain of the same size.


They give much more weight, usually two or
three times more,
to

losses than to gains  .

More academically, that theory states that most people (businessmen, investors...)
have
an asymmetric attitude between a gain prospect
and a loss (or risk) prospects
.

It is a quite irrational but quite common attitude.

Cookie example

You were happy in the cruise, a cookie in your right hand.

Until your cookie fell in the sea.

It was spoiling your day and you were in a bad mood

To offset the pain, and make you happy again,

the steward had to place three cookies in your left hand.

This is the price of the sentimental value you gave to that
lost cookie.

Investment example

When 250 is worth only 100.

People usually feel less frustrating

     * to miss a 100 (or even 200) Euros gain opportunity

     * than to suffer a 100 Euros loss.

To use economists' words:

The 100 Euros loss disutility (*) is higher

than the 100 or 200 Euros gain utility (**) see utility.

(*) or displeasure, undesirability (**) or pleasure, desirability)

The pain vs. pleasure feelings start to be
   balanced
when the gain opportunity is much higher
   than
the 100 Euros loss, usually something between 

200 and 300 Euros (*)

(*) this is indicative, the proportion between the acceptable gain

and the acceptable loss varies with the person, the time, the 
amounts at play, the precise probabilities...

Typically, people would chose an investment with a 50% probability to
lose 100 Euros only if it gives the same 50% probability to gain more
than 200 Euros.

Missing a 200 Euros gain so as not to lose 100 Euros.
A bit irrational
, isn't it?

This is a strange, but quite common, attitude, even if the prospect
theory is a little more complicated, as seen below.

Prospect theory and reference price

Old price tag kept within the brain.

Investors calculate those gains or losses from a reference point, actually
a reference price.

That reference is

Usually the initial cost of the deal or asset.

The state of affairs when the game started.

Or more emotionally, the hard earned money that had to be
forked out of the pocket.

Sometimes also be a previous market price high,

Or an old estimate, or a price objective that included an expected
    gain,

Or whatever mental anchor considered as a "good price": see
    anchoring
.

 

         

Utility scale =>

6

            x     x
                   

5

      x x        
                   

4

  x x            
                   

3

x        
GAINS
 
                   

2

                 
                   

1

                   

<= Price fall

Reference price =>

0

<= Reference price

Price rise =>

                  x

-1

                   
                   

-2

                   
   
LOSSES
      x  

-3

                   
              x    

-4

                   
            x    

-5

                   
          x      

-6

                   
      x x        

-7

                   
  x    

Disutility scale =>

-8

                   

Yes folks, the border to cross between painland and pleasureland
is a price!

Prospect theory and loss aversion

Better no loss than a profit?

The prospect theory, from which the loss aversion is derived (see
detailed article in this glossary), is one of the founding theories of Behavioral
Finance (by Kahneman and Tversky).

They found that investors have an irrational tendency
to be less willing to gamble with profits than with losses.

Most investors tend to become:

Risk takers (but loss averse ;-)
   when they start to lose.

=> They stick to their deficient holdings
       instead of selling
them to cut their loss, hoping they can get

 even in the future.
There is also
an illusion that all "fallen angels" are
"value stocks" (see those phrases).

=> Also, as seen in the shape of the curve, a little loss (or little

risk) is seen nearly as damaging as a large one

 All this is a dent in the expected utility theory


Risk averse when they start to gain.

=> They start "protecting" their gain, usually by selling 
      the asset for hard cash.

It might be a cause of short term volatility).

"Better be safe than sorry" seems to be the motto here.

This "reversal of preferences" also goes against the
utility theory.

This second finding is less reliable.

The opposite might happens in some exuberant periods.

Then many investors keep their purported beautiful holdings (selling aversion)
or even increase their bet, trying to amplify their gain, in a reaction of
overconfidence and good feeling.

Well, many pundits (some academic findings seems to support that
advice) recommend to "cut the losses and let the profit run", an
heuristic which may be wise as a trend-following (see that phrase)
strategy ...but not risk-free either.

About aversions

Aversion

* for loss,
* for risk
* and for selling one's belongings

are different colors of the aversion dress.

  
Risk aversion is not a specific case of loss aversion.

Risk aversion is about the comparison between:

A fully riskless proposal (that brings a small expected gain or
    income)

vs. one with a higher expected gain / income but that entails some
   
probability of loss.

Also loss aversion, as seen above, can revert risk aversion

Loss aversion is neither a selling aversion.

(also called endowment effect, disposition aversion).

In their aversion to sell, people consider that the assets
they own, whether they are losing or making money on them, are
always worth more than what the market offers.

See the general "aversion" article to explore the relations
between risk
aversion, prospect theory, loss aversion,
regret aversion, disposition effect...

(*) To find those messages: reach that BF group and, once there,
      1) click "messages", 2) enter your query in "search archives".

Members of the BF Group, please
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This page last update: 19/08/15  

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