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Prospect Theory: Affecting our Investment Prospects

Nov 26, 2015 by Priyanka Chakrabarty | 19 Downloaded
Picture courtesy - PIXABAY

We can certainly say the world is an uncertain one. While dwelling in midst of so many uncertainties, we also have to make decisions on a daily basis. We make some humdrum decisions like the menu for breakfast or the clothes to wear for work. We also have to make some life altering decisions that have the ability to leave an imprint on our lives like make a life plan or making a financial plan. We know we have to get it right, that is the only way we can live the life we have planned for. If you ever reflect upon the decisions that you had to make in the past, you will certainly realize one thing, we love to be safe. Most of the decisions you have made focused on keeping you, your family and your finances safe. You focused on minimizing losses rather than maximizing profits.

You might be getting ready to contest what I said because rationally speaking we look at minimizing losses and maximizing profits. Profits and losses are always looked upon as interlinked choices being inversely proportional. So, if profit increases the loss reduces and if the loss increases, the profits are reduced. Rationally speaking, we assess a situation by taking into account the net profit and loss. By taking a holistic view of the situation we decide whether a certain decision needs to be carried out.

We fail to take into account an important aspect: risk. When risk enters the picture, the scenario of profit and loss does not remain that simple. The higher the risk you take, you increase your chances of earning a profit and you also increase the chance of losses. So instead of dwelling in such a sticky situation, you take the simple way out of no profit no loss and focus on minimizing losses.

What is Prospect Theory

As the name suggests, prospect theory analyzes how you deal with prospects available to you. In 1979, Kahneman and Tversky presented the idea of Prospect Theory where they shed light upon the fact that individuals view profits and losses differently. We tend to view situations of perceived profits in a favourable light than situations of perceived losses.

Let us take an example, you have two choices: the first choice is you will get 5000. The second choice is you might win 10,000 but loose 50% of the money. Chances are you will go with the first choice because the perceived gain is higher than the second situation where you are losing 5000. Rationally speaking, in both the situations the profits are the same. However, the prospect of losing 5000 in the second situation makes an individual aversive to that situation. Hence, losses are weighed heavily in a scenario than the prospect of profit.

Prospect Theory and Mutual Funds

Prospect theory can be applied to analyse our investment behaviour. While making investments, the thought that dominates your mind is that the investment is a means to an end. The end is ensuring your secure financial future. You want your future to be secure, and the path often taken to ensure that is also a secure one. The mantra of a lot of investors is, security leads to secure future and uncertainty leads to uncertain future. This is how we deal with our investment prospects; looking for secure means to ensure a secure end. Have you ever wondered why penetration of Mutual Funds in India is as low as 10%? These are alarmingly low considering the population is nearly one and a half billion. The reason remains the same as has been highlighted by Prospect Theory. Investors deal with the prospects that are available to them.

Selecting Traditional Investments

The first prospect is a traditional investment avenue like fixed deposits, savings bank deposits, recurring deposits, postal deposits and so on. It allows investors to invest in these schemes and get assured returns on a periodic basis. It also provides capital protection. Hence, the investors are sure that at any given point of time the principal amount is not faced with uncertainties. They are also aware of the assured returns after a certain number of years. The situation is assessed by investors by weighing the possible losses against the possibility of profit. In this case, the possibility of loss is negligible. Hence, they view the situation as having minimized the losses and as a result maximizing the profits.

Why Not Mutual Funds

The second prospect is a one that involves uncertain gains and losses. It is commonly known as Mutual Funds and most investors tend to avoid this option. The first and most obvious reason being the lack of certainty. Mutual funds do not promise assured returns. Investors have a tendency to take a very sceptical look at stock markets or equities which thrives on uncertainty. Since Mutual Funds are indirectly associated with the same they avoid it. Let us now take a better look at the reasons.

Certainty: When investors invest they look for some degree of certainty, if not absolute. This option is not available with Mutual Funds. Neither has it promised assured returns nor capital assurance. Therefore, Investors have a tendency to settle for 10% assured returns than risk their investment for 25% probable returns.

What are They Losing

Investors are settling for traditional investments are losing opportunities to make more out of their investments. Financially speaking, risk is not a negative word or aspect, which is how it is usually make it out to be. A lot of theories in finance are built around risk. Risk is seen essential to returns. It is viewed as compensation for investors who have invested with expectation of gaining higher than the actual return. Hence, risk is viewed in a positive light. So when an investor decides against Mutual Funds they lose out on higher returns that they could have gained with a little uncertainty.

Loss Aversion: We do not like to deal with losses, even perceived ones. When an investment presents the investor with a prospect of loss teamed up with probable profits, the loss aversive nature in the investor dominates. They avoid the investment and remove the slight insecurity. Investors tend to treat their losses much more importantly than their profits. A loss of 5000 outshines a profit of 10,000. You are bound to take more notice of the loss than that of the profit. This is the reason investors avoid Mutual Funds because of the perceived losses. The possibility of making a loss is daunting; hence the investments in Mutual Funds are avoided.

What are They Losing

Despite the stigma of loss being associated with stock markets and mutual funds they have known to be highest return generators. Mathematically it is proven that longer an investor invests in Mutual funds or equities, the volatility reduces over time and returns accumulate. This allows your investments to beat your own expectations of moderate returns with no risk. Even though, Mutual Funds cannot give in fine print promises of assured returns. There are funds which ensure that investors receive returns by taking minimum risk. Such options are a good place to start your investments if you are particularly risk aversive.

Relative Positioning:

We have a tendency to co relate profits and losses. If you are making a clean profit through your investments, it feels like you have gained much more. However, if you have made a neat profit tempered with losses, the profit will not feel the same. For example, you reaped a return of 20% in Mutual Funds, the profit makes you ecstatic. However, in another scenario you made a 30% returns and lost 10% of it in an investment. You are not going to feel as great about the profit. In both the scenarios the investor is gaining the same amount. However, the perspective investors tend to take of both the situations makes the difference of how we assess particular profits or losses.

What are They Losing

The relative positioning of profit and losses creates a barrier between you and an honest assessment of your investing situation. Instead of weighing losses more heavily than profits, try and take a more holistic approach to the situation. This allows you to make unbiased investing decisions and not biased ones.

Conclusion

We are presented with many investing prospects. How we deal with the prospects reflects upon our nature as investors. A lot of investors are slowly realizing that dwelling in absolute certainties and being risk aversive does not always lead to a secure financial future. It may lead to a financial future where you will not have enough to fulfil all your future financial goals. Traditional investments do not provide inflation adjusted returns or compounded returns. While you continue to receive assured returns, they are not enough and you are probably aware of that. Hence, a little uncertainty takes you a long way. They allow you to dwell in the realm of risk and returns and depending on the risk you decide to take, you get returns. As an investor you might want to check upon the highest return generators over the years to reduce the last speck of doubt you may have. Delve into uncertainties for a certain future.

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Priyanka Chakrabarty

A literature enthusiast who loves to write. An ardent social worker who dreams of bringing about change and hopes to do so through her writing. A firm believer of the saying pen is mightier than the sword, Priyanka is an English Honours graduate. She also pursed Diploma in Wealth Management Practice from IIFP and is a certified social media expert.

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