Video Player - Training the Investor Brain: Prospect Theory

Training the Investor Brain: Prospect Theory

  • Date: December 8, 2016
  • Duration: 3min 7sec
  • Speakers: Robert Schmidt
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Transcript

As part of our “Training the Investor Brain” presentation and materials, we discuss Prospect Theory which says losses hurt twice as much as comparable gains feel good. So if you lose $1,000 in the stock market, but gain that $1,000 back, you’re even. But you may not FEEL like you’re even. You still may FEEL like you lost money.

Consider this example to help illustrate the effects of Prospect Theory. Let’s say we have two couples (the Folgers and the Rogers).

Both have the same amount of money invested in the same portfolio – and it’s an amazing portfolio. In fact, it’s grown 15% each year for 20 years and has a very reasonable 10% standard deviation.

While most couples would be THRILLED to have this portfolio, if you look at the picture, we see the Folgers do indeed seem pretty happy. But the Rogers are worried and miserable. Even their dog looks worried. What’s the difference?

Look at the picture.

The Rogers are sitting in front of their computer. The difference between these couples could be something as simple as how frequently they look at their statements!

Remember, when we see a loss – even a paper loss – it’s twice as bad emotionally as seeing a gain. Put a different way, seeing a gain is like earning 1 positive emotional unit. But seeing a loss is like LOSING TWO emotional units.

Now, with this fantastic portfolio, if the returns were normally distributed, you would still see a loss about half the time if you looked at it every day. With computer access and smart phones today, people can check on their portfolios every hour, every minute – or every second! If they did that – they likely would see a gain about 50% of the time. And that will make them feel miserable.

It’s only when you look at your account balance once a month do you really increase the likelihood of seeing a gain. If you can hold off and look at it once a quarter, you’d see a gain 77% of the time. Look at it once a year and you’d see a gain 93% of the time.

With these statistics, we created a handout called the Brandes Wheel of Investor Emotion.

The size of a dessert plate, it essentially shows the statistics I just talked about. We created this wheel to show the emotional impact that checking your account can have. Again, even with this great portfolio, if you checked it every day, you’re likely to see a gain about half the time. And you might end up feeling like this little emoji – frustrated, worried, stressed. But if you rotate the wheel to reveal monthly, quarterly and yearly numbers, you likely will end up feeling better and better. It’s why we say, “Keep Calm. Check Less.” Or “Checking less reduces stress.”

This is one of the tools I said I’d introduce to help manage emotions. It’s designed to help point out the devastating effects that fear and a short-term focus can have when investing.

Brandes Investment Partners “Training the Investor Brain” suite of materials are designed to help better manage our emotions when investing. Contact us for more information about any of these materials.

Disclosures

Standard deviation measures variation around an average. 

The recommended reading has been prepared by independent sources which are not affiliated with Brandes Investment Partners. Any securities mentioned reflect independent analysts’ opinions and are not recommendations of Brandes Investment Partners. These materials are recommended for information purposes only and should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any security.

The hypothetical examples contained herein are for illustrative purposes only. The examples do not take taxes and investment expenses into consideration, nor do they represent the performance of any particular investment. Actual results will vary. Source: Fooled by Randomness: The Hidden Role of Chance in the Markets and in Life, by Nassim Nicholas Taleb. Publisher: W. W. Norton & Company (October 2001) ISBN-10: 1587990717

No investment strategy can assure a profit or protect against loss.

The foregoing reflects the thoughts and opinions of Brandes Investment Partners® exclusively and is subject to change without notice. Brandes Investment Partners® is a registered trademark of Brandes Investment Partners, L.P. in the United States and Canada.