[0:00]Hi everyone, this is Sandeep Anand. If there is one concept in behavioral economics that stands out and has maximum influence and impact on human behavior in uncertain circumstances like stock market,
[0:12]I would call that out as prospect theory. Now, this was a Nobel Prize winning concept created by Daniel Kahneman and Tversky, two leading, you know, behavioral economist.
[0:24]Daniel Kahneman was known for winning Nobel Prize for multiple contribution of his towards behavioral science and economics.
[0:30]And he's also known for his much celebrated book Thinking Fast and Slow. But among all his work, I feel prospect theory stands out.
[0:39]Why because it really analyzes people's behavior and an attitude under loss making and profit making circumstances.
[0:46]And it's something called as loss aversion. Now, loss aversion is a derived concept from prospect theory.
[0:52]And it pretty much deals with, you know, people how people hate losing much more than they winning by a factor of almost two to three times according to Kahneman.
[1:03]Now, all of it is to do with a starting reference point or an origin point. Whatever below that reference point, or you can call it as expectation point, let's take.
[1:13]Whatever you get, whatever people get below that expectations point will inflict a lot of pain of loss for human beings.
[1:21]And whatever above that reference point was as expected, and that gain will not have as much impact as losing out something, and that behavior is called loss aversion.
[1:31]Now, let us get into a practical example of loss aversion. Let us ask a trader to choose between two circumstances or two situations.
[1:39]You create a bet or a gamble and flip a coin. Ask the trader to choose between two circumstances.
[1:46]Say like, you know, the heads trader wins $1,000, if it falls on tails, the trader does not win anything, zero.
[1:53]But if the trader does not take a bet at all, the trader ends up getting surely $200. What would the trader choose?
[2:02]Put yourself in that situation. That's how we human beings typically behave in a positive quadrant which is a loss aversion behavior because we tend to gain to that $200 and choose not to take that bet most of the humans.
[2:15]Now, invert the situation on its head and create a situation where, you know, put a circumstances, if it falls on head, the trader loses out $1,000.
[2:25]And if it falls on tails, the trader loses nothing, zero. But if the trader chooses not to take the bet at all, the trader ends up losing $200 for sure.
[2:37]Put ourselves in that behavior. What would he choose? We will definitely take that, most often, take that bet and try to, you know, stick to that $200 what we have and not lose that.
[2:47]And, you know, the, and what if it ends up getting the bet of $1,000 in our favor?
[2:53]That is called a loss, or risk taking behavior. So, there's a risk aversion behavior and there is a risk seeking behavior.
[3:00]The risk aversion is the first condition where the trader chooses not to take the bet, and most often, humans behave in that circumstances.
[3:10]We try to be risk averse, that is a positive quadrant, or the first quadrant. Now, if you take the second situation, that is called the risk seeking behavior, which falls into third quadrant.
[3:20]You look at the sharp drop of that curve, that kink that is created. That kink is due to the loss inflicting behavior that human beings, you know, create, because not to lose.
[3:30]The lose, the losing part will create so much pain, it will inflict so much pain on human beings than the gain.
[3:38]And that's why the curvature on the positive quadrant or the risk averse quadrant is more concave and an inverted convex on the third quadrant.
[3:46]Now, this is a very brilliant concept where human beings tend to not lose, and there are many inconsistencies or biases created in the stock market.
[3:54]Now, let us get into that and see how this curvature influences our behavior, and see what are those inconsistencies and also how to overcome those inconsistencies.
[4:06]Now, what are these stock market inconsistencies of prospect theory application? The most common, you know, inconsistency is something called as a disposition effect.
[4:14]It's an anomaly actually discovered in behavioral science of behavior of finance. It relates to the tendency of investors to sell assets that has increased in value, while keeping the assets that have dropped in value.
[4:27]Now what I mean by this is, we would have all experienced this when a stock that we own goes down 20, 25%. However bad the company, even if we realize that the company is bad, we tend to hold on to that company so that it, the value price reaches back to zero and we don't end up in a loss.
[4:46]And the moment it hits zero, we sell it out. And same in the opposite condition, when a price goes up 30% or 50%, most of the people try to sell it out early so that they can retain the gain they made.
[4:56]And most often people, you know, sell it out after a stock doubles.
[5:03]That is a usual, you know, threshold value. Nobody waits for 50 times, 100 times. These two behavior are in sync with the prospect theory.
[5:10]The human tendency to stick on to what we already gain or what we already own is loss aversion.
[5:17]Now, the effect of this, the disposition effect can be minimized, uh how can we minimize that? It's important to minimize it because we want to increase our gains in the stock market.
[5:25]It can be minimized by a mental approach called hedonic framing. It's a way to make gains feel stronger and make losses feel less stronger.
[5:35]It's through our mindset and training our mindset to feel that way, which makes us stick on to the gains and winners for long and cut out the losers, in if we understand that it's a mistake that we did.
[5:46]The second most common inconsistency is something called as move to perceived safety asset. Now this happens in a completely different circumstance.
[5:54]When there is a complete market crash, like a broad market crash that happened in 2008,
[6:00]that happened in 2020 or 2000 NASDAQ. In such kind of broad market fall or a crash, when it falls 20, 30, 40, 50% unabated,
[6:14]people tend to be scared. They will not hold on to that losses. They will try to recover whatever is left.
[6:21]If after the market crashes 50%, if your portfolio is down 50%, you tend to behave in a very different circumstance.
[6:29]We tend to sell out everything, whatever you have left, try to recover that, put it into a perceived safety asset, something like a bond or a fixed deposit or a savings deposit.
[6:36]Where you get a minimal interest, but you're okay with that, and you think that stock market is not a place for me. Let me rather recover and stay in this. I will never enter back stock market.
[6:47]A majority of the new age or less experienced folks in the stock market behave this way, and this is something called as move to perceived safety asset behavior.
[6:53]Again, it's a loss aversion to behavior, but it's not a wise behavior because eventually the market would mean revert.
[7:00]And it is an unnecessary loss that you're booking for a notional loss that could have been recovered.
[7:07]Let's take an example, which a recent example. I mean, this might not be an exact situation, but I want to take an example.
[7:12]How you would feel. Suppose you, we all know Tesla stock, which went up four, five times last one and a half years, two years.
[7:19]But think that, assume that you missed all that, and you only bought it in November 2020 or October 2020.
[7:26]And from that point, the Tesla stock has doubled in the last three months where it hit the peak around the reference point of, you know, 880.
[7:33]That was a peak, I believe in January 2021. And say in Jan 2021, you, let's take that as a reference point at the peak valuation, that is 880.
[7:44]So, you had, say put $10,000, you got a 20K, it stands at 20K in Jan 2021. You're pretty happy it happened.
[7:53]Although you did not get the full benefit of 4, five times, but you're still happy it doubled by with just that just within three months.
[8:00]Now, come March or Feb 2021, the stock has corrected almost 36% from that point.
[8:08]So, you would have ended up with almost like 12K, which was supposed to be 20K, it would have come down to 12K.
[8:18]You are still at a gain with a 2K gain, but you'll feel really bad for not booking out profits on that, the 10K that you had.
[8:29]That's a loss inflicting pain, you know, it causes much pain than the gain that would have had in in a doubling. Now, this is what I wanted to, uh, you know, bring about in the prospect theory and how that applies in human creating human inconsistencies, so that we overcome these inconsistencies to be successful in the markets.
