29 May 2018
By Alastair MacLeod
Most of us know that buying a lottery ticket is a waste of money. The chances of winning are so remote as to be unachievable, yet most of us have probably bought a lottery ticket at some point in our lives.
Prospect theory can explain this behaviour. Prospect theory is useful for investors, particularly those who are approaching, or in, retirement. Understanding how people make decisions in the real world is the best starting point for constructing investment portfolios that allow investors to stay the course.
The term ‘prospect theory’ describes how people choose between different options (or prospects) and how they estimate the perceived likelihood of each of these options. Human nature being what it is, estimates are often biased or incorrect.
Prospect theory was developed as a pragmatic model for explaining real-world choices and why people do not make the optimal, logical decision.
Prospect theory in contrast to utility theory
The theory was a dramatic departure from previous models (e.g. utility theory), where decision making was assumed by academics to be perfectly rational. Utility theory claimed that probability-weighted outcomes served as the basis for determining risk
on the final wealth outcome (i.e. the probability-weighted return) and rely on this as a key consideration in decision making.
In contrast, prospect theory claims that investors are more likely to prioritise gains or losses from a current reference point and treat these gains or losses differently from a value perspective.
In other words, the path of investment returns is more important than the final wealth destination.
A critical consideration in assessing this path is the concept of loss aversion. Put simply, the pain felt from losing $100 is sharper than the joy of making $100. If the path of investment returns encounters losses – more probable in a volatile asset class like equities – then investors will focus on the ‘journey down’ and sensation of loss, rather than the longer-term probability weighted return of the asset class. It is exactly at this point that adverse investment decisions are often made.
Insurance is the mirror image of buying lottery tickets, and is a good example of how prospect theory works. Even though the likelihood of a costly event may be miniscule, most of us would rather agree to a smaller, certain loss (the premium paid) than risking a large expense. The perceived likelihood of a major health problem is greater than the actual probability of that event occurring. There’s a reason insurance companies are some of the oldest on the planet.
There are numerous examples of people underestimating common risks. For example, a recent study of Australian hospital data reported that nearly 40% of all injury-related hospital admissions in Australia were due to falls, versus 13% for transport-related accidents. For Australians aged over 65, the rate for falls increases to more than three-quarters of all hospital admissions. And yet most of us perceive driving to be a riskier activity than the daily event of taking a shower.
Another consideration in prospect theory is mental accounting, which describes the process whereby people have different ‘mental bank accounts’ for different expenditures. For example, people tend to have a greater willingness to pay for goods using a credit card than cash, even though they draw upon the same resource. People are unable to focus on the final wealth outcome, instead they assess the individual transactions differently.
Utility theory and prospect theory do overlap in that as wealth or gains increase, the marginal value or utility progressively declines. In other words, the joy felt from a $1000 investment moving up to $1010 is less than the joy felt from a $100 investment moving up to $110. The absolute gain is the same, but we value relative gains differently to absolute gains.
Retirement planning with prospect theory in mind
So what does this mean for retirement planning? If a financial strategy is going to deliver the benefits and outcomes it was designed for, it is important that investors ‘stay the course’ and remain invested with a consistent long-term strategy.
However, at certain points along the investment journey, investors are likely to experience powerful emotional forces that can derail their longer-term investment objectives. Armed with an understanding of prospect theory, investors can recognise the pull of their emotional magnets and incorporate these into a comprehensive investment plan, making it more likely they will stick to their plans.
Based on this, it makes sense for investor portfolios to address three key issues:
1. Losses are felt more acutely than gains
As the GFC proved, retirees are more likely to disinvest during market stresses at precisely the wrong time than other age groups. This behavioural bias during drawdowns is compounded by the separate concept of sequencing risk, which can also serve to materially impair outcomes for retirees.
As such, capital protection is vital during periods of market weakness. This usually only comes at some cost of foregone investment returns. Capital protection cannot be considered in isolation (without some risk there can be no return). As a result, some approaches to capital protection such as a high allocation to cash can perversely increase risk as they simply increase the certainty of investment returns not delivering a portfolio’s objective.
The key is to improve the shape of returns to minimise drawdowns, delivering a growth profile with capital protection.
2. Investors value more certain returns above more ambiguous returns
In equity markets, this helps explain the typical Australian retail investor’s focus on distributions, where regular bank account deposits can unfortunately be prized more highly than the accompanying capital fluctuations in the unit price. While there may be some comfort for retirees from regular payments, the more important metric is ‘total return’, which includes movements in the unit or share price alongside distributions.
Within this total return focus, income can play a critical role by providing:
- greater certainty, especially in low growth environments when real returns are difficult to generate, and
- increased predictability, as the range of possible investment outcomes can be narrowed.
3. Investors’ sense of value diminishes as gains increase
Underperformance in a strong positive market is less important to an investor’s sense of value, especially in relation to stronger performance in a lower growth or negative market.
To help manage these issues, it makes sense to build retirement portfolios that are designed to deliver growth, but with a return profile that mirrors our humanistic biases and include elements of loss aversion and income certainty.
For investors, this can assist in dialling down the pull of our emotional magnets, and result in an increased likelihood of adhering to long-term plans and thus achieving better outcomes.