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Of all the advantages conferred upon me by my training in behavioural finance, I did not expect getting free beers to be one of them. Let me explain.
I recently caught up with a friend to watch a game of football. Halfway into the game, however, my friend started complaining that the year ended badly for his company, and he wasn’t likely to get his bonus. He said if that happened, he would have to delay his purchase of a fridge. What piqued my interest was his subsequent comment. Suddenly forgetting all about the fridge, he said if he did in fact end up getting a bonus, he would just save it and put it in his bank account.
I realised then that my friend was a real-life carrier of prospect theory.
Prospect theory suggests that people feel losses more acutely than gains even if the end result is the same. This was empirically proven in 1979 by Kahneman and Tversky, and has been used to explain why people tend to reduce their expenses when their actual income against expectations falls, but do not increase their spending by the same proportion when their income against expectations rises.
To understand how the prospect theory actually works, consider the example of an investor who has just bought some stock. When the price of this stock increases, he makes a profit on paper but becomes more risk averse as a result. On the contrary, if the price of this stock decreases, he makes a loss on paper but becomes more risk-loving as a result. The combination of this asymmetrical behaviour implies that this investor will become more and more inclined to hold on to a losing stock the deeper it falls, in the hope of an opportunistic gain in the event of a rebound. He will, however, quickly sell the winning stock just to avoid a loss in case of downturns.
Experiments in prospect theory have also discovered that people are more likely to avoid a choice framed as a potential loss and embrace a choice framed as a potential win, even if the outcome is the same. This brings me back to my story. In my friend’s case, framing his choice to save his money as a loss was my opportunity at a free beer.
I told him that if he chose to simply put his money in a bank, the interest from it would be so low that all his gains would pretty much be nullified by inflation. I said to him, “Compared to the few cents you make from your interest each month, spending money to buy beer for your witty friend will make you a much happier man!”
Falling straight into the trap, my friend got us a couple of cold ones. When I explained the prospect theory to him, we had a good laugh about it.
Jokes aside, this could happen to anyone. So the next time you are about to make an investment or purchase decision of any kind, ask yourself – is the reasoning behind your decision based on logic, or are you an unwitting victim of the prospect theory?
Dr. Jack Hong is the co-founder of Research Room Pte. Ltd., a management consulting and advanced analytics company that delivers complex prediction and decision-making capabilities for commercial, government, and not-for-profit organisations. Dr. Hong has extensive research and commercial experience in applying advanced empirical science to drive business, financial and policy value chains. He is concurrently an adjunct faculty with the Singapore Management University (SMU).