Good morning & happy Monday!
“He who loses money, loses much; he who loses a friend, loses much more; he who loses faith, loses all.”
– Eleanor Roosevelt, former First Lady of the United States
Let’s say I had a coin and two people with $1,000. Let’s say both individuals put their $1,000 on the table and agreed that the winner of the coin flip would get $2,000 and the other person would walk away empty handed. Would you be interested in being one of those two people? Would you put your $1,000 on the table with those odds?
I most certainly would not.
Today I want to briefly introduce the topic of prospect theory. It is a very in-depth analysis that won its author Daniel Kahneman a Nobel Prize in Economic Sciences in 2002 (I can tell you are excited 😉). Attached you will find the full 30-page research paper on the topic … it’s a real page turner 😉.
It is a fascinating topic because the theory basically states that making money feels good, but losing money feels about twice as bad as making money feels good.
Going back to the coin flip example, person #1 who won the coin flip and turned $1,000 into $2,000 would feel really good about that outcome. But person #2 who lost the $1,000 would feel absolutely horrible.
Let’s say both participants have a baseline happiness score of 50. After the win the person who won might gain 25 “happy points” to go from 50 to 75, but the person who lost would have a happiness score drop 50 points from 50 to 0.
Prospect theory says that the positive emotional benefit the person who has won is much less than the negative emotional drain that the loser of the funds had. In other words, losing feels way worse than winning feels good.
Let’s say the odds were changed a bit. Instead of a coin flip let’s say it’s a dice with 6 sides. If the dice lands on numbers 1, 2, 3 or 4 you win and if it lands on numbers 5 or 6 you lose. Would you put $1,000 on the table for those odds?
Intellectually we would say “the odds are dramatically in my favor with me winning 2 out of 3 times” but the emotional part of us likely would caution “you could lose $1,000.”
What if you played the game and the dice landed on #5? You play again and the dice again lands on #5. You play 3 more times with the dice landing on #6, #5 and #6. You are now down $5,000. What do you do?
The wisest financial decision is to keep playing as the odds continue to be in your favor, but it’s going to be increasingly difficult to plop another grand on the table following a string of 5 losses in a row and a wallet with $5,000 less in it.
That’s prospect theory in action.
I do believe this theory is accurate based on my own experience and observations. If a client’s investments are up 25% they are pretty happy, but if a client’s investments are down 25% they are massively bummed. My phone is pretty quiet during periods of time when the market is doing really well … I get a lot more phone calls when the market is down.
Is this logical? No. Is it real? Absolutely.
We are human beings, we are not machines or robots. We have emotions and feelings and all of that must be factored into how we manage our portfolios and corresponding financial plans.
This seems like an opportune time for me to reinforce that investing is not gambling. We are investing in real companies that make real products and generate real services for real people and turn a real profit for doing so. But, the value of those businesses change over time as market forces change. We as investors should never lose sight of that. We are not gambling in a game with the favor in our odds, we are investing in companies.
As the chart below shows, since 1980 (my birth year) the S&P 500 is positive 32 out of 43 years (74.4% of the time) with an average return of 8.7%. How painful was 2022 in comparison to how good 2019, 2020 & 2021 were? My guess is you felt a whole lot more anxiety about 2022 than you felt joy in 2019-2021. That’s prospect theory.
Being aware of our natural emotional response to losses and keeping our emotions in check is a critical component of successful investing.
One of my primary job functions as your financial advisor is to help you avoid making critical mistakes during emotionally challenging seasons. In other words, I hope to help you navigate the negative emotions that prospect theory states you are most likely experiencing during temporary market downturns.
I plan on discussing this specific chart in a little further next week as there are some fascinating observations to be made.
In the meantime, hope it is a wonderful, productive week ahead!