HOW USING PROSPECT THEORY CAN HELP YOU INVEST MORE CONFIDENTLY

Luke Milholland CFP®,ChFC®,CLU®

luke@vaultwealthstrategies.com
Investing
3
MIN READ

WHAT IS PROSPECT THEORY?

And How Using It Can Create A Better Investment Experience


In 2002, Israeli-American psychologist Daniel Kahneman, was awarded a Nobel Prize for his work on Prospect Theory - a behavioral economics framework based on the psychology of judgement and decision making.  

Instead taking a prescriptive approach of focusing on what people should do or how decisions should be made, Prospect Theory takes a descriptive approach that focuses on how people actually make decision under uncertainty.


What made Prospect Theory different was that it took a descriptive approach rather than the same prescriptive approaches of earlier academic studies. Instead of focusing on how decisions under uncertainty should be made, it focuses on how people actually make decisions under uncertainty.

Given the option people tend to make choices that minimize losses more than gambling for potential gains.

An experiment was done where people were given two scenarios: one that had two options for gains and another with two options for losses.


In regards to gains, 80% of respondents preferred a certain gain of $3,000 over an 80% chance of $4,000 with a 20% chance of gaining nothing.


Conversely, when faced with negative prospects, 92% of respondents preferred to take their chances on an 80% chance of losing $4,000 with a 20% chance of losing nothing over a certain loss of $3,000.


Regardless of positioning, respondents chose a lower expected value to avoid losses.


HOW WE USE PROSPECT THEORY TO DELIVER A BETTER INVESTMENT EXPERIENCE

Drawing on the Nobel Prize winning scientific framework of Prospect Theory and the utilization of practical and effective technology, we help investors measure their true risk preference. We take into account what constitutes a “devastating” loss or an “acceptable” gain given their personal circumstances. This enables them to make decisions based on their actual financial position.

Why is this important?


Because far too many people are unnecessarily suffering from OPI or Oblivious Portfolio Incongruity*.


What this means is that their current investment approach (or lack thereof) is incongruent with how they should be invested based on how they would actually respond in times of uncertainty. While OPI isn’t an officially recognized diagnosis (yet!), the unsettling feeling that comes from not knowing how your portfolio might perform in times of uncertainty is real.

This can slip by unnoticed in times of market tranquility, but unclear expectations lead to bad expectations that ultimately sabotage efforts when markets decline.


As opposed to providing the same ole adage of “invest for the long term and don’t worry about it”, we help you set a predetermined “devastating” loss threshold over a relatively short period of time (6 months). Having a 95% statistical probability of not losing more than a predetermined level of risk enables you to invest more fearlessly.

*I just made that term up. Don’t google it. It’s not a real thing... Although it should be!


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