The Master’s Minute – Prospect Theory

The Master’s Minute – Prospect Theory

May 14th 2019 | Posted in Blog, Master's Minute

When I was a young boy, I always enjoyed Thursday mornings with my mom. That was the day each week that we would go grocery shopping.

Rarely would my mom buy something that was not on sale, and never would she buy something not on sale that we didn’t need. If you grew up in a house like mine, sales ruled the day. In my house today, they still do! (Thanks, Mom!)

So why then, do we not like when stocks are on ‘on sale’?

Part of this phenomenon relates to a behavioral finance concept known as Prospect Theory. In short, Prospect Theory shows that as humans, we hate losses more than we love gains when it comes to investments. Most of us would prefer less downside than more upside when assessing a risk.

This was big news to the economists of the world, because the assumption of the day was that human emotions did not factor into economic decisions. Prospect Theory was the first glimpse into the effect of human emotions on financial decisions, and in general, it meant that a lot of us humans make sub-optimal economic decisions!

In fact, it’s why many investors end up buying high and selling low instead of the opposite, despite knowing that we have that axiom backwards!

When it comes to investing, we need to be aware of our emotions. We need to look at downturns in the market like sales at the grocery store, instead of letting our emotions tell us how scary a downturn can be.

We need to look at the stock market like Mom and me shop for groceries, sales rule the day!

Garrison R. North | CFP Managing Partner

Email Garrison R. North

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