Prospect theory is a behavioural finance theory that attempts to explain human decision-making behaviour as it really is, rather than assuming rationality. It starts with loss aversion which is an asymmetric form of risk aversion. It says that the positive utility (happiness) of £1 gained is less than the negative (absolute) utility of £1 lost. That is, losses hurt more than gains feel nice. Graphically:
The utility curve with loss aversion is non-linear and asymmetric, with a very steep left-hand side dip for only small losses. The right-hand side is much flatter; the equivalent gain yields much lower utility.
How does it matter for investors in the real world? In investment, prospect theory encourages us to look at non symmetrical risk measures that don’t assume a normal distribution. For example, we can consider downside volatility instead of volatility, or the Sortino ratio instead of the Sharpe ratio. We can also use VaR and conditional VaR (aka expected loss) instead of volatility if the method for calculating VaR is either non-parametric or parameterised using a non-normal distribution.
Prospect theory also encourages us to apply strict discipline with respect to stop losses and profit targets, but particularly the former. This can essentially cap losses to a level where utility doesn’t take too much of a hit. We also make greater use of structured products and non-linear derivatives such as options to create payoff profiles that are favourable in the context of prospect theory utility.
Finally, in wealth planning we can make use of annuities and other guarantees to make sure there is an income floor – or some other type of floor – that again prevents utility from falling too low.
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