Friday, May 1, 2009

"Prospect Theory: An Analysis of Decisions Under Risk,"

"Only when you combine sound intellect with emotional discipline, you get rational behaviour"-- Warren Buffett

Ravi is a smart, intelligent and young techie with MBA (finance) from a reputed business school. He constructed a smart and sizeable portfolio in 2004, which multiplied six times as the market rallied from 4000 to 20000 levels. He felt very happy looking at his paper profits, which never translated into real money.

After seeing new highs, which are followed by sharp corrections of 2004 and 2006, my friend assumed the bull market was eternal and the 2008 correction too would follow the same pattern and scale new milestones such as 25000 and 30000. Then, the inevitable happened, as Mr Market, who generously rewarded long-term investors for four years, embarked on a southward journey. My friend's portfolio, which was loaded with small and midcap stocks, melted like wax in no time.

Why did Ravi fail to book profits? Did he fall in love with the bull market? Did he become a victim of his own greed?

Following the footsteps of Baron Rothschild, an 18th century British banker who famously said, "The time to buy is when there is blood in the street," I advised Ravi to go for staggered buying and build a new portfolio when the Sensex was trading at sub-10000 levels, merely because stocks were available at lower prices.

Ravi has enough risk appetite and stomach to hold on to his scrips for the longer term. But to my surprise, he turned down my advice and worried that the market may come down to 6000 levels.

What prompted Ravi, who was bold enough to consider buying even at 20000 levels, to shy away from the market when he got the opportunity to buy at much lesser prices? Fear?

Yes, Ravi succumbed to his emotions by letting greed and fear influence his decision-making and acted in a manner contrary to his own financial interest.

Is this type of behaviour limited only to Ravi? No, this type of behaviour is common to most investors. Even professional money managers fall in love with bull markets and behave irrationally.

For more insight into investor behaviour and to understand how emotions impact our decision making and force us to act against our own financial interest, let us try to understand what is known as the 'prospect theory'.

Prospect theory
The theory was developed by Daniel Kahneman of the department of psychology at Princeton University and Amos Tversky.

Their seminal work, "Prospect Theory: An Analysis of Decisions Under Risk," which was published in the journal of Econometrica in 1979, has the distinction of being the second-most cited article during the 1975-2000.

The article states that investors have an irrational tendency to be less willing to gamble with profits than with losses and explains how investors make decisions when confronted with risk. It also shows how fear of losing and greed for gains impact our decision making. It also empirically proved that investors are not risk averse but they are loss averse.

Kahneman was felicitated for his work done in collaboration with Tversky with Nobel Prize in Economics for the year 2002.

Prospect theory identifies two behavioural anomalies, as far as our losses are concerned viz. loss aversion and sunk cost fallacy.

Loss aversion
Loss aversion refers to people's tendency to strongly prefer avoiding losses to acquiring gains.Kahneman and Tversky empirically proved this.

Say you participated in a television game show. There, you are confronted with the following two situations:

Situation I
You are given Rs 10,000 and two options:
Guaranteed win of Rs 5,000
Sealed envelope, which contains either real notes of Rs 10,000 or mere white papers
Which option will you choose?

Situation II
You are given Rs 10,000 and two options:
Guaranteed loss of Rs 5,000
Flip of a coin. If it is heads, you will lose Rs 8,000 and if it is tails, you won't lose anything.

Which option will you choose?
Research suggests that you will choose the first option in Situation I as there is a guaranteed win of Rs 5,000 where as in Situation II you will choose the second option as you don't want to take a guaranteed loss of Rs 5,000. Instead, you prefer to test your luck by going for a flip of a coin. It is this attitude that makes gamblers so popular with casinos.

When we apply the same concept to stock markets, we see similar type of behaviour among investors. For instance, X bought MIC Electronics at Rs 250. The stock tumbled to 75. At this juncture, he has the opportunity to book his losses and invest in a better counter. But he prefers to reduce his cost of purchase by investing in the same scrip with the intention of 'break even'. It happens because investors are reluctant to book losses.

Research suggests that the pain of loss is twice the pleasure of gain. It may be the reason investors are so reluctant to get out of the counter, even their investment decision proved wrong and unfruitful. Loss aversion also forces the investors to book profits very quickly at early stages of rally without riding the profits. In fact, the success of investors lies in riding the winners and cutting the losses. But in practice they behave in opposite direction hurting their own financial interest.

Sunk cost fallacy
Sunk cost fallacy is another form of loss aversion. It shows the inability of investors to forget the money incurred and investors tend to base their future decisions based on money already spent.

For instance, X joined the one year executive MBA programme. He found the programme boring and not in line with his career objectives. He has the option of discontinuing the course and do whatever interests him. But he decides to continue in it just because he paid the money. By reluctantly doing so, he is not only wasting additional money on the course but also his valuable time.

In stock markets, averaging the cost price with the intention of breakeven is the best example of sunk cost fallacy. It is like throwing good money after bad.

In case of gains, investors suffer from biases like status quo, i.e. inability to make decisions, and endowment effect, i.e. falling in love with what you own.
It is always said that markets did well, but investors fared poorly. Investors too can do well by identifying their own behavioural anomalies and refraining from repeating the same mistakes.

The writer is technical analyst, Darashaw & Co, Mumbai. Views are personal.

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