As we head into the dog days of winter, many people are feeling a sense of disconnectedness. Many people have gone months without seeing their extended families and phone calls and zoom calls have replaced good old-fashioned face to face contact over the winter months. There might even be a bit of lethargy taking root. Given the sense of ennui, I thought I’d ask something a little more animated this time – how might one apply Prospect Theory to everyday advice?
As a refresher, Prospect Theory is something that was dreamed up by the brilliant social scientists Daniel Kahneman and Amos Tversky more than a generation ago. Kahneman won the Nobel prize in Economics for his contribution in 2002 and wrote a massively successful book, Thinking Fast and Slow (has it already been a decade?). Prospect Theory deals with decision-making in an uncertain world. What Kahneman discovered is that people tend to be risk-averse when things look good but will often seek out risk when times are more difficult in an effort of avoid losses that might otherwise materialize.
The big breakthrough was the idea of a reference point (typically a point where one neither makes nor loses money) and the intensity of one’s attitudes depending on what side of the point you’re on. People tend to feel the pain of a loss about twice as strongly as they feel the joy of a gain. Some have suggested that, certainly over the long run, gains are “normal”, perhaps even expected. As such, it is entirely consistent with human emotion for people to feel the way they do. The thing is that, until recently, finance was the domain of pure profit and loss. The emotional baggage one accumulated along the way was often deemed secondary at most, but more likely totally inconsequential.
My concern rests with many advisors’ value propositions. Many purport to be good behavioural coaches. I’m curious what people think. When assessing an advisor’s ability as a behavioural coach, is it better to maximize return or to minimize discomfort? A case could be made for either, obviously, but can one perspective be unambiguously better than the other? For instance, if two investors each have $1 million and portfolios drop by 20% because of a massive (say 33%) drop in the stock market, both would likely feel a pang of regret as a result. Suppose one client decided it was too much and decided to sell everything at that point, but the other stayed the course. Was the advisor who cause the client to stay invested the “better advisor”? Maybe. Let’s say the answer is ‘yes’.
That brings up a first-derivative question. If the person who sold everything could have been persuaded not to sell everything by, for instance, hedging some portion of their portfolio against a major drawdown, would the advisor who implemented the hedge be better than that advisor who did not? Again, let’s say the answer is ‘yes’.
The challenge I’m hinting at is one of applied Prospect Theory. Many people understand what it teaches us in practice, but I seldom see advisors articulate a way where they make recommendations that are directly designed to take Prospect Theory into account. I find it curious that many people laud people like Kahneman for their brilliant insights, yet very few people do much to try to implement the findings. It’s as if people like the moral of the story but are unwilling to even attempt to make recommendations that apply Prospect Theory for retail investors. The textbook version of decision-making never seems to make it into the real world.