This is a gross oversimplification, but some experts believe that there are two pathways in our brain that help us make decisions. Dr. Daniel Kahneman described this larger part of our brain, the sub-cortex, as System 1. As it says here, Kahneman argued it does the “fast thinking.” It operates automatically with little or no effort or control. This is the part of our brain that may have suggested 10 cents in that brain teaser question about the bat and the ball.
Another part of our brain, the pre-frontal cortex, is System 2. This is the part of our brain we engage when we have to solve more complex problems.
Kahneman, pictured here, wrote a fascinating book called “Thinking Fast and Slow” about these parts of our brain and how we make decisions. He won a Nobel Prize in economics. Now, winning a Nobel Prize is pretty amazing – even more amazing when you consider that Kahneman is not an economist. He’s a psychologist. He won the Nobel Prize for his work with Amos Tversky in creating Prospect Theory. Let’s look at how Prospect Theory can adversely affect our decisions.
In short, Prospect Theory says losses hurt TWICE as much as a comparable gain feels good.
So if we lose $1,000 in the stock market, but we gain that $1,000 back, we are even. But we don’t FEEL like we’re even. We still may FEEL like we lost money.
We tried to summarize this with that little formula: Fear = 2 times Greed. We also tried to illustrate it with this graph. Note how sharply the line slopes down for losses vs. this gradual upward slope for a gain. The fear – or the pain – we feel from losing money is twice as great as the joy of earning the same amount. This helps explain why we feel so disappointed – even cheated – when the market declines. And it could be any market – stock market, bond market, real estate market. It doesn’t matter. It also doesn’t matter if the loss is realized or not. Just SEEING that the account value went down will trigger this feeling. It’s really powerful – and may help explain why we react the way they do when we SEE losses.
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.Disclosure
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.
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