Prospect Theory

Imagine I proposed the following gamble on a coin toss:

• If the coin shows tails, you lose $100.

• If the coin shows heads, you win $150.

Do you accept the gamble?

The probability says yes, take the bet every time, but according to the results of Daniel Kahneman's experiments, most people will not accept the gamble. Despite the positive expected value, the discomfort of losing $100 outweighs the possible gain of $150.

This one economic concept tells us so much about our behaviour as investors.

So many of us fear losing far more than we love winning, and this single trait dictates what we do with our money.

 Regret Minimisation

The S&P 500 has returned roughly 10% a year on average over the last 20 years.

S&P 500 Returns by Year

There has never been a 20 year period in the history of the stock market that has resulted in negative returns.

Probability of a lower S&P 500 by Number of Years Invested

As such, the probability dictates that exposure to the stock market will generate positive returns over the long term. 

With this in mind, it seems strange that such a wealth-creation machine is overlooked by so many.

But as humans, it’s never just about probability. Our decision-making process is a spider web of cognitive biases and emotional irrationalities.

We all hate uncertainty, so our brain optimises for regret minimisation, not probability.

This loss aversion creates a false narrative that gives us peace of mind - ‘Why bother starting… ’ It’s too risky.’

So we end up making no decisions at all, and the money just sits there….

Again, all this makes perfect sense. It’s how we are wired, but the game has changed over the last 18 months. 

As interest rates rise, there are now ‘risk-free’ returns on the table for even the most risk-averse among us. 

Doing nothing with your savings isn’t ‘playing it safe’ anymore; it’s laziness. Cash is yielding 5.2%... That’s over 5% for taking no risk. 

The stories you have been telling yourself about the risks of investing are no longer valid. You just need to find the approach that’s right for you. 

Take the time to figure out your behavioural quirks and what you want from your money, and you will find an investment plan that fits.

Whatever you do, don’t just do nothing.

Thanks for reading

I'm always happy to chat all things investing so send me your thoughts [email protected]