Academic theory of the financial world is often built upon one main assumption: that people are perfectly rational in making economic decisions and that these rational decisions by individuals help to create a high degree of efficiency in the broader financial markets. Efficient markets work, as the theory goes, because all actors are behaving in ways to maximize their own self-interest. And usually this is how markets, and economies, function effectively and efficiently.
The field of behavioral finance has a different take on financial markets—indeed, it is the study of when individuals behave differently from what might otherwise be the most rational behavior. Behavioral finance studies the imperfect nature of the economy and the markets, when individual investors actually make decisions that are not perfectly rational. In other words, why do investors sometimes make decisions that appear to be against their own self-interest? The study of behavioral finance is very interesting and provides a few important insights into the investment decisions, and biases, of the average investor.
One of the most prominent concepts in behavioral finance is called “prospect theory.” Prospect theory states that for the average individual, it is much more painful to lose something that you have already owned than the comparative pleasure of gaining something new.
By way of example, suppose you have $1 and it is taken away from you. You now have $0. There is a certain amount of pain associated with losing this dollar. Now suppose you have $0, and you are then given $1 dollar. You gain a certain amount of pleasure by receiving the $1. It turns out that for most people, the loss of $1 is much more painful than the gaining of $1. Given that in both cases $1 is either won or lost, a rational outcome would be that a person would have the equivalent amount of pleasure for gaining $1 as they would pain for losing $1. But this is not the case.
How might prospect theory apply to investing? If you are a moderate risk investor starting with a $5 million portfolio, you would likely invest in a “balanced” portfolio that would have a blend of stocks and bonds. Now suppose the markets experience a large sell-off and the portfolio that was formerly worth $5 million is now worth $4 million. This would represent a 20% loss.
Prospect theory would suggest that this investor would experience pain in losing 20% of their capital. So much pain, in fact, that they would be willing to accept a higher degree of risk than normal, in order to “win back” their capital and return to their $5 million starting point. One of the key insights of prospect theory is that in trying to get back to even, formerly risk-averse investors will take far greater risk to get back what they formerly had.
As advisors, we must also be aware of this concept with respect to the risk level of client portfolios. Because losses are more painful than gains are pleasurable, it is paramount that we are aware of client risk levels—even when they may express a preference for more risk in their asset allocation. When developing a plan for clients, minimizing volatility is important on a number of levels. As part of the process in building a client’s Retirement Shock Absorber®, reducing portfolio risk is a very important component.
We welcome the insights that behavioral finance can give us, because it can help us improve the client experience. With the knowledge that preventing losses is often as important, or more important, than providing big gains, we can build investment portfolios for clients that are built for long-term successful outcomes.
 Kahneman, Daniel, and Amos Tversky. “Prospect theory: An analysis of decision under risk.” Handbook of the fundamentals of financial decision making: Part I. 2013. 99-127.