Perspective theory - behavioural finance

Perspective theory

Traditionally, it is believed that the net effects of the profits and losses involved in each choice are combined to present an overall assessment that determines whether a choice is desirable. Academics tend to use the term "utility" to describe satisfaction and claim that we prefer situations that maximise our utility.

However, research has shown that we don't process information rationally. In 1979, Kahneman and Tversky introduced an idea called perspective theory, which supports the fact that people appreciate gains and losses differently. They base their decisions mainly on the probability of gains rather than potential losses, even when they achieve the same economic result.

According to perspective theory, losses have a greater impact on traders' emotions than an equivalent amount of profit. For example, in a traditional way of thinking, the amount of utility earned with a profit of 50 must be equal to a situation in which a trader earns 100 and loses 50. In both cases, the final result is a net profit of 50.

Despite the fact that traders always end up with a gain of €50, most consider that a single gain of €50 is better than winning €100 and losing €50. This is proof of irrational behavior.

Kahneman and Tversky conducted a series of studies in which subjects answered questions that involved judgments between two monetary decisions having potential losses and gains. For example, the following questions were used in their study:

You have €1,000 and you must choose one of the following options:

  • Choice A: You have a 50% chance of earning €1,000, and a 50% chance of earning €0
  • Choice B: You have a 100% chance of earning 500.

You have €2,000 and you must choose one of the following options:

  • Choice A: You have a 50% chance of losing 1,000, and a 50% chance of losing €0
  • Choice B: You have a 100% chance of losing 500.

People who choose "B" are more risk averse than those who choose "A". However, the results of this study showed that an overwhelming majority of people chose "B" in question 1 and "A" in question 2. People are therefore more willing to choose a reasonable level of earnings (even if they have a reasonable chance of earning more), but are willing to engage in risky behaviour to limit their losses. In other words, losses carry more weight than an equivalent amount of profit.

This line of thought created the asymmetric value function:

This function is a representation of the differences in utility (amounts of pain or pleasure) that are obtained as a result of a certain amount of profit or loss. It is essential to note that not everyone necessarily has a value function that looks exactly like this; this is simply the overall trend. The most obvious characteristic is how a loss creates a greater sense of pain than the pleasure created by an equivalent gain. For example, the amount of pleasure generated by a 50 profit is less than the amount of pain that is caused by a €50 loss.

Therefore, when multiple profit and loss events occur, each event is assessed separately and combined to create a cumulative feeling. Depending on the value function, if you earn 50, but then lose them shortly afterwards, this has an overall effect of -40 utility units (a 50 profit gives 10 pleasure points, but a 50 loss gives -50 points).

 

Financial pertinence

Perspective theory can be used to explain some illogical financial behaviour. For example, there are people who don't want to put their money in the bank to earn interest or who refuse to work overtime because they don't want to pay more taxes. These people could benefit from additional after-tax funds, but perspective theory suggests that the benefit (or utility gained) from the additional money is not sufficient to overcome the sense of loss incurred by paying taxes.

Perspective theory also explains the emergence of the disposition effect, which is a tendency to hold losing positions for too long and sell winning ones too early. Proper logic would be to keep the winning stocks in order to favour profits and sell the losing stocks in order to avoid escalating losses. This represents typical risk aversion behaviour.

The other side of the coin is that since investors hold their losses for too long, they are willing to assume a higher level of risk in order to avoid the negative utility of a potential loss. Unfortunately, many losing assets never recover and losses increase with often disastrous results.

 

Avoiding disposition effect

It is possible to minimise the disposition effect by using a concept called hedonic framing to change your mental approach.

For example, in situations where you have the choice of thinking about a large benefit or several small benefits (such as looking for 100 compared to looking for two 50 bills), thinking about the latter can maximise the amount of positive utility you obtain.

And conversely, for situations where you have the choice of thinking about a large loss or several small losses, the situation featuring a large loss would generate less negative utility.

For situations where you have the choice of thinking about a large gain with a small loss, creating a small profit (€100 and -€55 = +€45 ), you will receive more positive benefit from the small profit.

Lastly, for situations where you have the choice of thinking about a large loss with a small profit, creating a small loss (-€100 and +€55 = -€45), it would be better to try to manage the situation by separating the gains and the losses.

Try these methods to frame your thoughts and make your experience more positive while minimising the disposition effect.

Contents - behavioural finance theory