As a human, it’s hard to admit that we are complex creatures.
Especially in markets.
In fact, the human brain is wired in a way that makes objective thinking very difficult.
Inherent biases and cognitive flaws – such as the confirmation bias, the hindsight bias, and the recency bias1 – all cloud our judgment and investing decisions.
Making things worse, psychologists believe there are over 1802 of these cognitive biases.
The bright side? At least it’s not our conscious fault.
But what may be our fault is not taking the time to learn about these biases and flaws that deeply impact our decisions.
So, while all of these are worth studying, I believe two specific concepts are important for investors to grasp.
And that’s prospect theory - otherwise known as loss aversion – and identity claiming.
These are two important topics worth understanding to try and improve decision-making when most are prone to falling for their irrational human biases.
And that may make all the difference for a financial advisor.
Prospect Theory: People Really Hate Losing
So, what exactly is prospect theory?
In short, it’s a theory that Daniel Kahneman and Amos Tversky – both famous behavioral economists – created in 1979 to try and explain how people irrationally process information regarding gains and losses.
Put simply, humans value losses and gains very differently. Specifically, individuals really don’t like losses – no matter how small the stakes.
And this may skew how investors judge risk and reward.
Imagine you have $100, and you are presented with two different scenarios:
Scenario 1: You can keep your $100 without any changes.
Scenario 2: You have the chance to gain an additional $100, doubling your money to $200, but there's a risk involved. There's a 50% chance you'll double your money to $200, and a 50% chance you'll lose $100, leaving you with only $0.
According to prospect theory, most people would feel differently about these two scenarios, even though the expected value (average outcome) is the same for both.
In Scenario 1, where you keep your $100, you are in a certain and safe position. People tend to find this option relatively more attractive because they dislike losing what they already have.
In Scenario 2, where there's a 50% chance of gaining $100 and a 50% chance of losing $100, the expected value is the same as Scenario 1 ($100).
However, many people would be risk-averse (aka shun risk) in this situation, feeling that the potential loss of $100 outweighs the gain, even though the expected value is the same.
This theory had compelling implications. Most notably, humans don’t view risk and reward symmetrically.
In fact, some studies3 have shown that humans feel losses two-and-a-half times (2.5x) more than equivalent gains.
Kahneman and Tversky’s work on this behavioral flaw led to other great concepts in behavioral finance.
For instance, the sunk-cost fallacy – which is the bias towards continuing a poor strategy because of the time, money, and effort already invested into it – was based on prospect theory’s findings.
Many investors may hold onto losing positions – hoping for a rebound that never comes – because selling at a loss causes emotional distress (even if it’s the better option).
Thus, because of prospect theory, conventional financial wisdom suffered a serious blow, such as the Efficient Market Hypothesis - which assumes that markets are always rational and efficient.
Once you begin realizing how flawed human minds are, and how markets are open social systems, I believe it’s clear how irrational and inefficient things may truly be.
Identity Claiming: Experts Also Really Hate Being Wrong
Another interesting cognitive flaw is that humans seem to despise being wrong.
In Kathryn Schulz’s book– ‘Being Wrong: Adventures in the Margin of Error’ (2010) – there’s some great insight into this dilemma.
She wrote, “Our love of being right is best understood as our fear of being wrong.”
Put simply, humans tend to believe they know exactly what’s happening and why, which is reinforced by trying very hard not to think about the possibility of ever being wrong.
Furthermore, researchers Caroline Bartel and Jane Dutton explained4 that in both our words and deeds, humans always express how we see ourselves –whether conscious or not - and thus how we want others to perceive us.
This is known as ‘identity claiming’.
So, when proven wrong, many experience the harsh realization that the identity we may have claimed for ourselves — an expert, the guru, etc. — has suffered. Which can negatively affect the ego.
This may reinforce poor decision-making and bad judgment because the pain of admitting wrongdoing is heavy (especially against peers). Hence doubling down may seem like the better option.
Because of this, it’s difficult for investors to find experts they trust. Those who are humble enough to admit mistakes and not take them personally.
The Babe Ruth Effect
So, why does all this matter?
Because it shows us that the crowd tends to focus on the frequency of magnitude. Not the magnitude of correctness.
Or, put simply, humans are much happier when they’re right frequently and don’t suffer any losses.
And while this isn’t exactly shocking, it shows how most think and behave when making decisions – especially in markets.
Michael Mauboussin – the head of consilient research at Morgan Stanley - wrote this clearly in a whitepaper5 from 2002, “The frequency of correctness does not matter; it is the magnitude of correctness that matters. Say that you own four stocks and that three of the stocks go down a bit but the fourth rises substantially. The portfolio will perform well even as the majority of the stocks decline”
This is also known as the ‘Babe Ruth Effect’ - because even though Ruth struck out a lot, he was one of baseball’s greatest hitters.
This makes sense, right?
Well, the problem is that humans are hardwired to feel those losses and mistakes much more deeply. Thus, we may focus on avoiding any potential downside even when the upside is more attractive.
Putting this into perspective, Mauboussin references the book ‘Fooled by Randomness’ (2001) by Nassim Taleb.
“In a meeting with his fellow traders, a colleague asked Taleb about his view of the market. He responded that he thought there was a high probability that the market would go up slightly over the next week. Pressed further, he assigned a 70% probability to the upmove.
Someone in the meeting then noted that Taleb was short a large quantity of S&P 500 futures—a bet that the market would go down—seemingly in contrast to his “bullish” outlook.”
He clarified his thought process in Babe Ruth’s terms…
Although he (and the crowd) believed the most probable outcome was for the market to rise – the low chance the market declined created an asymmetric opportunity (greater upside vs. downside risk).
Why? Because the high-probable outcome (70%) was priced in already because markets are relatively efficient.
In his eyes, there wasn’t much more to gain.
But on the off chance the market does decline (a 30% chance in this example) – the effect is dramatic as the market re-prices the news.
Thus, in Taleb’s mind, he saw that betting on the high-probability outcome had a negative expected value.
Many were puzzled by Taleb's strategy because it implied frequent small losses. And as I noted above, humans tend to feel losses more strongly than gains. So, it didn't seem very attractive.
In fact, it must’ve appeared unnatural (thanks to human biases).
But – just like Babe Ruth – when it hit, it really hit.
The complexity of human nature plays a profound role in shaping our decision-making processes, especially when it comes to investment choices.
Biases and cognitive flaws like prospect theory and identity claiming, which help us understand our natural fear of losses and our hesitance to admit mistakes, are just a couple of the many biases that psychologists have discovered.
More importantly, these cognitive biases can have significant consequences in financial markets, challenging traditional beliefs like the Efficient Market Hypothesis and emphasizing the need to recognize the emotional aspects of decision-making.
But instead of falling prey to such biases, I believe it’s prudent to try and understand them to enhance decision-making potential when others may lose their heads.
That’s why we have done so much work on these topics for financial advisors to use – such as our video, “Using Emotions as Your Investment Guide Could Cost You6.”
It’s that important.
By understanding our cognitive limitations, we can hope to become more effective and rational, even in the face of our complex and often irrational human nature.
But don’t expect it to be easy.
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