Yesterday, Daniel Kahneman, the founding father of behavioural finance, died at age 90. He was born in Tel Aviv, Israel, in 1934. He trained as a psychologist, and together with his friend and long-time collaborator, Amos Tversky, went on to develop a whole new branch of economics and psychology by looking at human judgement, decision-making under uncertainty, and risk perception. This led to his winning the Noble Prize in Economics in 2002 for Prospect Theory, which he and Tversky developed in the 1960’s. He was a professor at many institutions, but most notably, he was a tenured professor at Princeton.
As a thinker and a trader, the human mind always played a big part in my daily thought process. It fascinated me, it interested me, and it frankly amazed me. I had already studied the rational approach to finance and economics at a graduate level, but irrational anomalies I encountered in my trading career led me to believe that the conventional wisdom that “the rational man” theory driving decision-making was simply not entirely true.
In 2005, I embarked on a Ph.D. with a focus on behavioural finance to deepen my understanding of this subject. My area of interest was cum-dividend pricing. My thesis proved that in the build-up to the dividend date, price displayed irrational behaviour that suggested investors and traders treated cash differently than conventional finance suggested it should. It relates to a form of mental accounting, another behavioural finance theory that won Richard Thaler a Nobel Prize in this growing new branch of economics. Enough about me; let me get back to the major contribution Kahneman made. It is really cool.
Prospect Theory
Most people have become familiar with the idea through Kahneman’s most incredible book, “Thinking Fast and Slow,” which became an instant best seller. His ability to use simple examples and easy language to explain complex matters is a true gift. If you haven’t read it you should.
Diverging from the classical economic assumption that individuals are rational actors who always make decisions that maximize their utility. This theory is particularly relevant to investing, as it highlights how investors might deviate from optimal decision-making due to psychological biases and heuristics. Heuristics is a fancy word for using mental shortcuts.
A core concept of Prospect Theory is that people evaluate gains and losses relative to a specific reference point (often their current wealth) rather than in absolute terms. Investors are generally more sensitive to losses than to equivalent gains, a phenomenon known as loss aversion. For example, the pain experienced from losing $1,000 in the stock market is typically more intense than the pleasure of gaining $1,000. This can lead investors to behave irrationally, such as holding onto losing stocks for too long to avoid realising a loss or selling winning stocks too early to lock in gains.
Let me try and show you an s-shaped value function which shows value (emotional reaction) to gains and losses. You can first see that losses create a much bigger impact on value/emotion. What you can also see, although not as easy to notice on the chart, is that there is a diminishing gain as one makes more. With losses, there is initially an increasing value of loss, which eventually reaches a point of diminishing loss. To use fancy scientific language, according to the value function of Kahneman and Tversky, gains are concave and losses are convex.
To conclude, I think the biggest gift a trader or investor can gain from this theory is that you should know that we are all programmed to behave irrationally, and therefore you have to build a system or process that helps you identify when you are behaving irrationally so as to avoid financial ruin or underperformance. By simply focusing on stripping this behaviour out of your investment process will automatically raise your performance to above average.