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Behaviourial Investing – Prospect Theory

Following on from my Hudson report last month, again I would like to explore some more of the behaviourial biases that exist when it comes to investing.

The key fundamentals of Prospect theory are that human beings are non-rational decision makers, and that experiencing a loss has a greater emotional impact than experiencing a gain of the same value. Although not specified in the theory, I would propose that this is because, to some extent, you are expecting the gain. Otherwise why would you have invested in the first place? So if the gain occurs you intrinsically think, “there you go, I knew it, just as I planned” and it is not so shocking.

Regardless of why, studies have shown that the pain of losing $100 is more intense than the pleasure in winning $100. In fact, it is estimated it is twice as intense, suggesting that if someone challenged you to a coin toss where if you lost you part with $100, you would require a win of $200 to make it worthwhile.

Possible impact on your investment decision …

Imagine a scenario where you can take a guaranteed $250 gain OR can gamble on a 25% chance of a $1,000 gain and a 75% chance of gaining nothing. Most people will take the $250, mainly because it is guaranteed.

Now reverse the situation and imagine that you can accept a guaranteed $250 loss, OR can gamble on a 25% chance of losing $1,000 and a 75% chance of losing nothing. Most people will opt to gamble, because they can’t stomach the idea of a guaranteed loss.

Although the situation was the same, their inclination not to experience a loss got the better of them. In a way prospect theory is linked to the disposition effect I have discussed in previous articles, whereby people tend to keep losing stocks and sell ones that have gained.

Behavourial biases such as the above are one reason why a managed investment (such as a managed fund, Exchange traded fund or Listed Investment Company) can be advantageous, because they tend to follow a disciplined investment process and are less susceptible to emotion.

Behaviourial Investing – Herd Bevaviour

You can probably guess what this is and how it works. Like many animals, human beings can be prone to move with the masses. I.e. Sell in a falling market and buy in a rising market. This can then cause bubbles that inevitably pop. Bubbles can only be identified once the fall has occurred, which for many will be too late.

Herd behaviour can be driven by:

  • Greed in a rising market and the desire not to miss out.
  • Fear and panic in a falling market.
  • An assumption that if everyone else is buying/selling they must be doing it for a good reason. This is very atypical of an inexperienced investor.

Since herd mentality does not take in to account any fundamental analysis it usually results in an undesirable outcome.

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