Investment Theory, Rational and Irrational - Essay Example

Investment Theory, Rational and Irrational (Word Count: 2118) Prospect Theory " People tend to fear losses more than they value gains. A $ 1 loss is more painful than the pleasure of a $ 1 gain." (Ginyard 2001) Man is a rational animal, proclaimed Aristotle. While we may be rational, we are yet animals and not robots. In most of the choices we make throughout our life, in fact, irrationality seems to be more reflected in our decisions than rational calculated thinking. We may regret our decisions so frequently, and yet we manage to learn from our folly seldom. Human beings are constantly susceptible to a plethora of subconscious tendencies originating from a domain that knows no semblance of logic or reason. Of course, when it comes to money and business we try to make a more balanced assessment of things, keeping our own personal biases aside to a large extent. For example, a man may instantly fall in love with a woman and propose to marry her, solely moved by the physical beauty of the woman; but this same man wouldn't invest in a company solely inspired by looking at the rich and luxuriant office premises of that company. He would definitely make further enquiries before he decides to take any step. In economics, or while making any kind of profit and loss decisions in general, we see men at their rational best. Nonetheless, human beings are still good old Homo Sapiens and the much anticipated rise of Homo Economicus never really took place. We make mistakes, we come under the sway of our emotions, we give in to our momentary whims often enough and later come to regret them as often enough. There are differences between person to person of course. Some of us are more intelligent, practical, cool-headed and experienced while arriving at decisions, while many others may not be as rational and practical. All in all, though, there has been found out to be a significant degree of irrationality and inconsistency at play when people make economic decisions. A hybrid branch of economics and psychology called behavioural finance has evolved to study the element of irrationality in the process of decision making; it endeavours to better understand and explain how emotions and cognitive errors influence people when they are making investment-related or other kinds of monetary decisions. But, in fact, behavioural economics consists of theories and empirical investigations into human response to risk, and as such its insights are relevant to any field where decision making is involved and a significant aspect of risk is present. A basic, and almost commonsensical, finding in this field of study is that people tend to be generally more risk-averse than generally thought of. In 1979, Daniel Kahneman and Amos Tversky propounded their "Prospect Theory," studying human behaviour in relation to risk. In essence what they have found out was that, contrary to the dictates of logic that were taken for granted in the standard expected utility theory of neo-classical economics, people placed different weights on gains and losses and on different ranges of probability. Translated in simple terms, this means that individuals are generally much more distressed by prospective losses than they are happy by equivalent gains. To give a more concrete measure to this rather subjective tendency, some economists have arrived at the conclusion that the difference is almost twice, i.e., people perceive the loss of 1 twice as painful as the pleasure derived from the gain of 1. But there is an interesting twist to this observation. It has been found that faced with a sure gain, individuals become risk-averse, while faced with a sure loss they become more willing to take risk. For example, between a situation of winning 10 for certain, and winning 20 or nothing each with a 50% chance - it has been shown that most people would go for the former. In a real-life situation, faced with a sure gain of 10, people become risk-averse and are less likely to go for 20 with only a 50% of chance. And when one extrapolates this situation to 100,000 in place of 10, and 200,000 in place of 20, even greater majority of people are likely to choose a totally certain 100,000 over a half certain 200,000 - because the more the assured gain, the less risk-prone people become. Such conclusions as these are based on many empirical studies conducted by economists and econometricists, most prominently by the pioneers Kahnemann and Tvesky themselves (Econometrica 1979). To support their case, these two researchers presented numerous studies in which people were asked to choose between gain and loss situations associated with varying degrees of probability. In one experiment, a group of people were given an option of making a sure gain of $500 and another option of gaining $1000 with only a 50% of chance, the remaining 50% chance linked to making no gain at all. And it turned out that 84% of the people chose the guaranteed $500 over the risky proposition $1000, though 50% is still a good chance. Disposition Effect Traditional economic theories, especially Von Neumann and Morgenstern's expected utility theory, consider individuals as perfect rational agents who are intelligently guided to efficiently maximize their profits and minimize their losses. This may be fine as far as theory goes, but falls woefully inadequate when it comes to describing and explaining the complexity of real life situations. While human beings are more or less rational creatures, their minds do not function with mechanical and mathematical precision, and thus enters the factor of irrationality into human decisions, especially into those decisions bearing an economic scope. But this is not to say that human beings act whimsically and inexplicably; fortunately, most of the time, there is a certain broad logic discernable in decisions people make, though these decisions may not strictly be compatible with the norms of rationality. Behavioral Economics is a study of "method" in the seeming madness of people taking economic decisions in a way starkly divergent from what would be expected on purely rational grounds. One of the interesting anomalies studied by behavioral finance is called disposition effect: it is an observed tendency among investors to hold on to losing transactions along with a disposition to sell away winning transactions. Such behavior has indeed been widely noticed. In a way, though, it conforms to the principles of rationality in that investors sell winners, as the prices of these assets have risen, and keep the losers, as the prices of these assets have fallen since purchase and have yet to rise. It only violates the assumptions of rationality because investors tend to sell away the winners too soon and keep the loosers for too long, as has been corroborated by extensive observations of finance researchers in this field. And this is what puzzles the economists. Shefrin and Statman (1985) were the first to draw attention to the substantial impact of this type of investor behavior tendency on capital markets. The disposition effect is defined as "investors' reluctance to crystalize investment losses relative to gains" (Shefrin, Statman 1985). Such a bias leading to sub-optimal investing pattern has been attributed to the prospect theory, that is, to the time-varying risk aversion based on the value fuction. Some of the other explanations offered to explain the disposition effect include the general belief of investors that today's losers would be tomorrow's winners (whether entirely justifiable or not), and investors' reluctance to sell off the losers due to the higher transaction costs associated with lower priced stocks. Prospect theory is founded on the propositions that people think about gains and losses while making gambles and not the final wealth levels, and that the regret from a loss is greater than the pleasure from a gain of equivalent magnitude (investors' utility functions are concave for gains and convex for losses) (Kahneman, Tversky 1992). The theory implies that investors employ a valuation function which reflects risk aversion in the domain of gains and risk seeking in the domain of losses . Hence the preference for a certain $100 to a 50:50 bet to win $0 or $200. Investigations in experimental settings (Weber and Camerer 1998) as well as real-life market settings (Odean 1998) have yielded findings consistent with the implications of the prospect theory. These results indicate the impact is substantial, thus supporting Shefrin and Statman's major premise that the assumption of complete rationality is inaccurate in realistic settings (Brown et al, 2002). Prospect theory appears to offer a simple way of understanding the disposition effect. If an individual investor is risk averse over gains, he should be inclined to sell a stock that is trading at a gain, in other words, a stock that has risen since purchase; and if he is risk-seeking over losses, he should be inclined to hold on to a stock that is trading at a loss. Researchers have been linking prospect theory and the disposition effect in this way for over 20 years (Barbaris, Xiong 2006). But Shefrin and Statman (1985) themselves put forward the regret theory as a possible alternative or complimentary explanation for the disposition effect. According to them, regret is "an emotional feeling associated with ex post knowledge that a difference past decision would have fared better than the one chosen." And this could be one of the factors resulting in the disposition effect. Regret theory is a motivational theory of decision making. Its basic assumption is that individuals are concerned with how the outcome of the decision is going to make them feel about the decision itself. According to Shiller (1998), regret theory can help explain the fact that investors defer the selling of stocks that have gone down in value and accelerate the selling of stocks that have gone up in value. Behavioural Finance The logical, rational, self-interested Economic Man of neo-classical economics is a myth. Regardless, a good deal of textbook economics is still based on this non-existent character. Actual human beings do not possess robot-like logic. Aristotle or not, man is a creature of passions and weaknesses. Any viable and comprehensive theory of decision making cannot abstract man from his contextual setting and place him in an abstract space, as did neo-classical economics. It was a gross simplification, though perhaps one that was needed at the time. However, for decades now, people have felt the need for a more practical theory to explain economic behaviour and decision-making, based on research and observations done on real people in action. There has been a need to integrate principles of pschology with the principles of investment, trading, and other areas of economics wherever psychology has a role to play. To fulfil this need emerged behavioural finance. It was a revolution of sorts in economic thinking. Neoclassical economics strangely sidelined all psychological considerations. It has a clinical purity, more than any of the economic theories that came before it or after. Kahneman and Tversky trace the origins of their approach to a paper by Daniel Bernoulli in 1738 in which an attempt was made to map money value onto experienced value or utility. In an attempt to solve his famous St. Petersburg paradox, David Bernoulli proposed the expected utility model. Bernoulli's argument was that the paradox could be resolved if decisionmakers displayed risk aversion. The first major extension of the expected utility theory was that of John von Neumann and Oskar Morgenstern. They used the assumption of expected utility maximization in deriving their mathematically elegant and rigorous game theory. The game theory was a pinnacle of intellectual achievement, no doubt, but it was seriously divorced from the real world of real people and real markets and real decisions. Nevertheless, it dominated decision theory for several decades, throughout 50s, 60s and 70s, even in spite of much criticism that was targeted at it. After Kahenman and Tversky published their paper "Prospect Theory," though, a variety of generalized expected utility models were developed with an intention of rectifying von Neumann and Morgenstern's theory while retaining the most attractive elements of it. Today, generalized utility theory is located in the mainstream of economic theory, in spite of it being a subfield of behavioural economics. In fact, behavioural economics itself is becoming more and more a part of mainstream economics. Its key advantage is that it has a critical mass of empirical research to back it up. Though many of its postulates have not yet been demonstrated or explained conclusively, behavioural finance/economics is just a young burgeoning disicipline, increasingly accepted and studied as part of mainstream economics. Today, behavioural economics is taught alongside the traditional financial and investment theories. Tomorrow it is bound to be integrated into their very content. The world happens in real time, and economics needs to describe this real world. References: BARBERIS, N., XIONG, W., 2006, What drives the disposition effect An analysis of a long-standing preference-based explanation, Thesis, Yale University and Princeton University BROWN P, CHAPPEL,N., ROSA,R.S., WALTER T, 2002, The Reach of the Disposition Effect: Large Sample Evidence Across Investor Classes, EFA 2002 Berlin Meetings Presented Paper, Universities of Western Australia, Sydney, New South Wales GINYARD, J.,2001. Position-sizing Effects on Trader Performance: An experimental analysis. Masters Thesis. Uppsala University. Department of Psychology KAHNEMAN, D., TVERSKY, A., 1979, "Prospect Theory: An Analysis of Decision Making Under Risk," Econometrica. Available from http://www.investorhome.com/psych.htm [Accessed on May 14 2006] ODEAN, T., 1998, Are Investor's Reluctant to Realise Their Losses The Journal of Finance 53, 1775-1798. SHEFRIN, H., STATMAN, M., 1985, The Disposition to Sell Winners Too Early and Ride Losers Too Long: Theory and Evidence, The Journal of Finance 40, 777-790. SHILLER, R., 1998, Human Behavior and the Efficiency of the Financial System, in The Handbook of Macroeconomics, 1999, North-Holland TVERSKY, A., KAHNEMAN, D., 1992, "Loss Aversion in Riskless Choice: A Reference-Dependence Model," The Quarterly Journal of Economics, 1040-1061. WEBER, M., CAMERER, C., 1998, The Disposition Effect in Securities Trading: An Experimental Analysis, Journal of Economic Behaviour and Organisation 33, 167-184. Read More