How Kahneman’s and Tversky’s Noble Prize Winning Prospect Theory can Improve Your Finances

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I finally did it!

A few weeks back, in a post about the behavior trap of Mental Accounting, I mentioned that my Grandpa passed on a few shares of stock to me. When the stock was given to me, it was worth around $30 a share. I sold it on 4/7/2011 for $3.04.

It hurts thinking about the money I lost from holding onto that stock. But what’s done is done.

Instead, of regretting this situation, the better use of time is to look at the psychological factors that played a role in my irrational behavior. Specifically, why did I continue to hold onto this stock, as it plummeted to $20, to $10, to $5, to $1.50, and back up to $3?

The entire time the stock plummeted, I knew it was the wrong thing to do. I’ve read research  explaining that once a stock get that low, it rarely goes back up. But yet, I couldn’t get myself to sell it. For whatever reason, I thought my situation was different.

Recently, while reading about Kahneman’s and Tversky’s prospect theory, I had an “aha” type moment. Their work, which they named prospect theory, perfectly explains my incredibly stupid decision to hold onto this stock.

Principles of Prospect Theory

The underlying principles of prospect theory, weren’t discovered overnight. Kahneman’s and Tversky’s goal was to develop a framework of how people manage risk and uncertainty. They did this with multiple studies, over a 30 year period.

In 2002, Kahneman was awarded the Noble Prize in Economics for his work.  Unfortunately, at that time, Tversky had passed, and wasn’t able to share the recognition.

Over a 30 year period, Kahneman and Tversky came to the following conclusions as to how people manage risk and uncertainty.

1. Loss Aversion – The pain of loss is greater than the pleasure of an equal gain. For example, the pain from losing a $100 bill, is worse then the pleasure from finding a $100 bill.
2. Reference Points – Decisions are made using reference points. These reference points change over time. For example, would you drive to a new dealership 30 minutes away, to save $20 on the purchase price of a $20,000 car. Probably not. Now, have you ever waited in line 30 minutes for free ice cream, which costs $3?
3. Break Even Effect – People seek risky behavior, for a chance to “break even”. For example, you bought a stock at $30, that’s now down to $20. Wanting to break even, you purchase more shares at $20.
4. Over-weigh Small Probabilities – People tend to severely over-weigh extremely small probabilities. There are actually some people who think they will win the lottery. (Or, the Cubs can win the World Series. And yes, I’m saying this as a Cubs fan.)
5. Under-weigh Large Probabilities – People tend to under-weigh the chance of a highly probable event from occurring. People invest thinking that there is “no way they can loose.”, then, they’re shocked once their portfolio is down.

Ways to Apply  the Principles of Prospect Theory to Improve Your Financial Decision Making

Beyond offering an explanation as to why I held onto my stock (I wanted to break even,  I was avoiding taking the loss, I used a reference point of $30 for the price per share), the principles of prospect theory explains many other irrational financial decisions that we make on a daily basis. The next step then is to look at specific ways you can apply these principles  to help improve your finances.

# 1 – Have Default Reference Points

Like it or not, your brain is going to continue to take shortcuts, as it does when it uses reference points.. Instead of avoiding reference points all together and relying on critical thinking, which is extremely hard under stress, you’re better off to continue to use reference points. However, instead of using “spur of the moment” reference points, like you did when you decided to not drive 30 minutes to save $20 on a new car, you can create default reference points in advance.

For example, what if you looked at saving $20, not as the chance to save .001%, but as an opportunity to buy something for $20 that fulfills you. Personally, I use 3 default reference points that I refer back to for making financial decisions.

1. $10 = A Book –  Every chance I have to save $10, is another chance I have to buy a book. Therefore, driving 30 minutes would have allowed me to buy two new books.
2. $100 = A Nice Dinner - Everytime I have a chance to save $100, I look at it as a chance to go out to a nice dinner with my wife, Natalie.
3. $1,000 =  A Trip – I feel that I can get to anyone in the world for $1,000. Therefore, everytime I have a chance to save in increments of $1,000, I look at is as a trip.

Putting this all together, imagine now I’m choosing between between two apartments.

• Apartment A – Good location, nice kitchen, two bathrooms for $1,200 a month.
• Apartment B – Average location, average kitchen, 1.5 bathroom for $1,000 a month.

Over a year, the difference in cost between A or B is $2,400. Or, using my default reference points, the difference in cost is 2 trips, 2 nice dinners, and 20 books.

Now, when I’m sitting in the Realtor’s office under pressure, with 2 people waiting anxiously for me to sign, I can make a better decision then saying, “Oh, it’s just $200 a month.”

# 2 – Match the Market with Index Funds

It’s really hard, as in almost impossible, to beat the market consistently. Out of the 300,000 million plus people in the U.S., only a handful of people have beaten the stock market’s returns over a 40 year period. Yet, year after year, the majority of investors try.

This is a prime example of how people over-weigh small probabilities.

# 3 – Rebalance on a Schedule

Prospect theory explains why investors sell winning stocks too soon, and hold on to loosing stocks too long. To contradict this behavior, stick to a rebalancing schedule. At specific times set in advance, rebalance to your desired asset allocation. If this sounds complicated, invest in a targeted retirement fund.

Kahneman’s and Tversky’s Prospect Theory | Conclusion

There is a lot more to Kahneman’s and Tversky’s prospect theory. The purpose of this post was was to introduce the basic concept, and list a few tactical things you can do today, to help make better financial decisions.

In the comments, mention if you’ve ever made any bad financial decisions that are attributed to:

1. Wanting to avoid a loss
2. The incorrect use of reference points
3. Your desire to break even
4. Over-weighing small probabilities
5. Under-weighing large probabilities

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Photo by: terren in Virgina

Tagged as: behavior, prospect theory