The Most Important Concept in Finance

You may have heard that Danny Kahneman died on March 27th, aged 90. Today, we will talk about his best idea and why it is so vital for long-term investors.

 

Kahneman (and his late research collaborator Amos Tversky) pioneered the study of cognitive biases and heuristics, revolutionizing our understanding of human decision making. Their research, notably in Prospect Theory, has had a significant impact on subjects as diverse as economics and public policy. They received a Nobel Prize for their efforts.

 

What’s Prospect Theory? 

 

Prospect theory, also known as “loss aversion,” revolutionized conventional thinking.

Before prospect theory, economists largely adhered to “rational choice theory,” assuming that individuals consistently made decisions to maximize their utility through rational calculations.

 

This theory presumed stable preferences, perfect information and consistent decision-making. It portrayed humans as rational actors consistently seeking the highest satisfaction or utility.

 

However, humans are inherently imperfect and prone to irrational behavior.

 

Recognizing these human tendencies, Kahneman (and Tversky) developed Prospect Theory.

 

They proposed that individuals evaluate potential gains and losses in comparison to a reference point, exhibiting a tendency to place greater weight on losses than equivalent gains, a phenomenon termed loss aversion. Additionally, prospect theory introduced the notion of “diminishing sensitivity,” wherein the perceived value of gains and losses diminishes as their magnitude increases.

For instance, winning $1000 does not feel 10x as rewarding as winning $100, despite rational expectations.

 

His research asked, then answered, questions like:

 

• Why do we sell our winners too soon and hold onto our losers too long?

• Why will we say yes to a risk with an 80% chance of success, but say no when asked instead if we’d incur the same risk with a 20% chance of failure?

• Why is money lost not the same as money gained?

 

Prospect theory is a fundamental truth of the human condition. But why should the long-term investor care?

 

Money is deeply intertwined with our emotions. It can evoke feelings of joy, security, greed, or despair. These emotional reactions often lead to irrational financial decisions.

 

Losses can be particularly difficult, making us fearful, risk-averse, and prone to panic. In response, many investors overreact by making changes to their portfolios at the worst possible times.

 

Prospect Theory and The Long-Term Investor

 

It’s a flaw, indeed. We tend to place undue emphasis on losses, an irrational quirk inherent in every individual. This flaw infiltrates our minds, subtly influencing our thoughts and decisions, whispering:

 

• Your portfolio is down. Maybe hold it longer and it will be up again...

• Your portfolio is down. Time to panic and sell everything.

• …run away and then never subject yourself to this again.

• …do something (even though it’s suboptimal), and do it now!

 

When Emmanuel Kant, Socrates and the Oracle at Delphi each echoed the sentiment “Know thyself” the stock market likely wasn’t their focus. Yet, they spoke to the essence of understanding human flaws. To know your flaws is the first step to overcoming them.

 

Loss aversion is a crucial problem that investors should be aware of and should be addressed from day one.

 

How to Fight Against Loss Aversion!

 

The ability to deal with losses is what separates successful investors from unsuccessful investors. You’re in trouble if losses cause you to overreact or make big mistakes at the worst possible moments.

The tendency to “sell to survive” in the face of losses is not a good investment strategy. But how can we proactively combat our natural loss aversion?

The key is to make allocation decisions with our irrationality in mind. As Kahneman and Tversky’s research has shown, the pain of loss is often twice as acute as the joy of winning. Recognizing this inherent bias is the first step.

 

Counteracting Loss Aversion 

 

To counteract loss aversion, we need to consciously override our emotional reactions. This means sticking to a well-thought-out investment plan, even when losses occur. It’s about maintaining discipline and not letting fear drive our decision-making.

 

The Importance of Perspective 

 

Keeping the big picture in mind is also crucial. Short-term losses are inevitable, but a long-term, diversified approach can help smooth out the volatility. Remembering that losses are a normal part of investing, not a personal failure, can also help us stay the course.

Enter diversification. Diversification’s fundamental benefit is reducing portfolio risk (pain) while maintaining portfolio reward.

The perfectly rational investor knows the losses are temporary and would stomach the larger loss from 100% stocks to achieve larger gains. But we’re flawed and monkey-brained. We care too much about losses. For many investors, the 90/10 portfolio is easier to stomach and stick with, i.e. 90% should be invested in less volatile assets such as ETFs and 10% and more risky stocks. While irrational, that’s reality; that’s the world we live in. That’s why Kahneman and Tversky’s work is impactful.

 

The “Scar tissue” that we all carry with us

 

Loss aversion can lead to persistent behavioral patterns, like avoiding investing after a negative experience. Consider those who suffered heavy losses during events like the GameStop saga or Enron’s collapse. Some concluded, “Stocks are too risky; I’m done with investing.” Less dramatic instances also occur, such as investors witnessing significant declines during market downturns like the Dot Com bubble burst or the Great Financial Crisis.

For some, one bad experience is enough to keep them out of the market indefinitely, leaving their money idle. This is far from ideal. I’d prefer to see investors maintain a steady, albeit conservative, portfolio mix throughout their investing journey rather than reacting impulsively to losses and retreating entirely. While a 90/10 portfolio might be overly cautious for some, it acknowledges the reality of loss aversion and helps mitigate its impact.