Ian Nar­ine

To e-mail or not to e-mail? Go to the po­lice or the pres­i­dent? Buy the stock now or wait for the pull back? De­ci­sions, de­ci­sions, de­ci­sions.

One was a tongue-in-cheek ques­tion, one ques­tion re­lat­ed to the pol­i­tics, the oth­er re­lat­ed to mon­ey. The ques­tions may seem far apart, but it all comes down to a ba­sic premise. That premise speaks to how we go about mak­ing de­ci­sions and that process of de­ci­sion mak­ing will im­pact the road that we trav­el and the out­comes that we achieve.

This dis­cus­sion can be re­lat­ed to any as­pect of life, but stick­ing to the top­ic of mon­ey and in­vest­ments for the time be­ing we can ap­proach the de­ci­sion-mak­ing process from two an­gles. We can ei­ther as­sume that peo­ple make de­ci­sions based on ra­tio­nal thought or ac­knowl­edge that peo­ple have bi­as­es that in­flu­ence their thought pat­terns and, ul­ti­mate­ly, their be­hav­iour.

If de­ci­sions are based on log­i­cal and ra­tio­nal thought, then one would be ex­pect­ed to weight the net ef­fect of gains and loss­es and then take a de­ci­sion that pro­vides the best re­turn for the low­est lev­el of po­ten­tial loss. Put an­oth­er way, the ra­tio­nal per­son will seek out the high­est util­i­ty (best use, most sat­is­fy­ing) op­tion.

It is, of course, clear that the de­ci­sions based on bi­as­es are more re­flec­tive of us as hu­man be­ings and this has lead to a body of re­search out of which comes a the­o­ry known as prospect the­o­ry.

Loss aver­sion

Ac­cord­ing to prospect the­o­ry, peo­ple will at­tach dif­fer­ent val­ues to gains and loss­es, even when faced with the same set of cir­cum­stances. The de­ci­sions tak­en will give pref­er­ence to per­ceived gains over any per­ceived loss­es. Here is the most com­mon­ly used ex­am­ple in or­der to il­lus­trate.

You should, if you are ra­tio­nal, be in­dif­fer­ent to re­ceiv­ing $100 ver­sus get­ting $200 and los­ing $100 since, at the end of the day you, end up with $100 ei­ther way. The risk re­turn trade off is ex­act­ly the same. How­ev­er, if you were to do a sur­vey of peo­ple, you would find that the ma­jor­i­ty would pre­fer to take the $100 rather than the $200. The sin­gle gain of $100 is pre­ferred to the big­ger gain of $200 com­bined with a loss of $100. The un­der­stand­ing comes from the fact that we don't like to lose.

Mar­keters will go through great lengths to take ad­van­tage of this per­cep­tion of gains be­ing pre­ferred to the per­cep­tion of loss and we can use some of the mu­tu­al fund ad­ver­tis­ing re­cent­ly seen in the news­pa­per to il­lus­trate.

You may have not­ed ads from mu­tu­al funds that show a big bold num­ber, some­thing like 50 per cent re­turns from in­cep­tion. You may no­tice oth­er ads that show the volatil­i­ty of re­turns over time.

Let us, for the sake of ar­gu­ment, as­sume that we are speak­ing about the ex­act same mu­tu­al fund.

In­vest­ment ad­vis­er A ap­proach­es you with the in­for­ma­tion that Mu­tu­al Fund X has re­turned 50 per cent since in­cep­tion. In­vest­ment ad­vis­er B ap­proach­es you with the in­for­ma­tion that Mu­tu­al Fund X has gen­er­at­ed above av­er­age re­turns over the past ten years, but the truth is the re­turns have been low­er over the last cou­ple years and that the fund did, in fact, lose mon­ey in some years.

The same in­for­ma­tion ex­cept that one is sen­sa­tion­al­ist and em­pha­sis­es the gains while the oth­er speaks more to the re­al­i­ty of the in­vestor ex­pe­ri­ence were they to in­vest. That re­al­i­ty is that mar­kets move up and down and while over­all, you are like­ly to gain, there is still the risk of loss.

Giv­en the sales pitch above, ad­vis­er A is more like­ly to get the busi­ness be­cause the in­vestors de­ci­sion will be bi­ased to­wards the fact that the gains were em­pha­sised by that ad­vis­er while ad­vis­er B, which pro­vid­ed a view that was more close­ly re­lat­ed to the re­al­i­ty of what you would ex­pe­ri­ence, would lose out.

Hope­ful­ly, you can now ap­pre­ci­ate the role that you play in skew­ing the fi­nan­cial ser­vices land­scape away from what is in your best in­ter­est to­wards what you are like­ly to want to hear. The same sce­nario ex­ists in pol­i­tics, re­la­tion­ships and many oth­er as­pects of life. This is why peo­ple will say on­ly what they think you want to hear as op­posed to the whole truth since the whole truth of­ten does not sell.

Ex­per­i­ment time

Un­der­stand­ing the ir­ra­tional el­e­ment as­so­ci­at­ed with most de­ci­sions, and coun­ter­bal­anc­ing that with a con­scious move to­wards more ra­tio­nal thought, is one of the keys to­wards bet­ter de­ci­sion mak­ing.

Here is an­oth­er ex­per­i­ment.

You are giv­en the fol­low­ing sce­nar­ios:

1. You have $1,000 and you must pick one of the fol­low­ing choic­es:

Choice A: You have a 50 per cent chance of gain­ing $1,000, and a 50 per cent chance of gain­ing $0.

Choice B: You have a 100 per cent chance of gain­ing $500.

2. You have $2,000 and you must pick one of the fol­low­ing choic­es:

Choice A: You have a 50 per cent chance of los­ing $1,000, and 50 per cent of los­ing $0.

Choice B: You have a 100 per cent chance of los­ing $500.

The above ques­tions formed part of a study on the top­ic. If the same set of ra­tio­nal rules ap­plied to both sce­nar­ios, you would se­lect A in Sce­nario 1 and 2 if you were more of a risk tak­er, and you would se­lect B in both sce­nar­ios if you were risk averse.

The re­sults of the study may sur­prise you in that an over­whelm­ing ma­jor­i­ty of peo­ple se­lect­ed op­tion B for sce­nario 1 (risk averse), but went for op­tion A in sce­nario 2 (risk tak­ing). The ex­pla­na­tion put for­ward by the re­searchers is that peo­ple are in­clined to set­tle for a rea­son­able lev­el of gains even where there is the pos­si­bil­i­ty of earn­ing more. In an in­vest­ment con­text, this ex­plains why a per­son will sell a win­ning stock even though it has the po­ten­tial to go high­er.

While this move may be seen as risk averse, the same per­son will prob­a­bly en­gage in a risk-seek­ing ac­tiv­i­ty when it is pos­si­ble to lim­it their loss­es. Once again in an in­vest­ment con­text, this ex­plains why a risk-averse in­vestor may hold on to a stock that is falling with the hope that it will re­cov­er.

In­sur­ing the lot­tery

Com­bined these two sce­nar­ios can ex­plain why a per­son will buy a stock that is ris­ing (be­cause they will fo­cus on the po­ten­tial gains) and keep a stock that is falling (be­cause they will try to re­cov­er the loss) even though the op­po­site should be the case.

In an­oth­er con­text, it is tan­ta­mount to pur­chas­ing in­sur­ance and buy­ing a lot­tery tick­et at the same time. One would ex­pect that the per­son who buys in­sur­ance would be risk averse since in­sur­ance trans­fers the risk from the pol­i­cy­hold­er to the in­sur­ance com­pa­ny for a fee. Yet that same per­son will buy a lot­tery tick­et which is a risk-seek­ing mea­sure where risk is pur­chased from the lot­tery agent, but the per­ceived loss is small be­cause the price of the lot­to tick­et is low.

Here is an­oth­er ap­pli­ca­tion. Stocks have out­per­formed bonds over the last 80 years, but peo­ple still see bonds as safer than stocks. Why? Sim­ple, peo­ple check their stock prices fre­quent­ly and be­cause of the fluc­tu­a­tions in prices, they are prone to ze­ro in on the po­ten­tial loss at a point in time and so be­come averse to hold­ing stocks.

If one were to check the val­ue of their stock port­fo­lio as of­ten as they do a val­u­a­tion on their house, they would see stock mar­ket in­vest­ing as no more or less risky than pur­chas­ing prop­er­ty, but many peo­ple will buy prop­er­ty but fear the stock mar­ket.

The les­son is that all of us are sus­cep­ti­ble to the ef­fects as de­scribed by prospect the­o­ry. How­ev­er, if you hold a fidu­cia­ry re­spon­si­bil­i­ty where one is mak­ing and tak­ing de­ci­sions on be­half of oth­er peo­ple, it is not suf­fi­cient to im­pute your bi­as­es and loss aver­sion in­to the equa­tion, but one must step out­side and view the sit­u­a­tion from the per­spec­tive of those whose in­ter­ests we are sup­posed to rep­re­sent.

That is es­sen­tial­ly the dif­fer­ence be­tween the pro­fes­sion­al and the lay per­son for this is what the pro­fes­sion­al is paid to do each and every day.

There­fore, when judg­ing the ac­tions of your in­vest­ment pro­fes­sion­al or any oth­er per­son with a fidu­cia­ry re­spon­si­bil­i­ty, it should be on the ba­sis of what is the most ra­tio­nal de­ci­sion tak­en. That de­ci­sion is the one that pro­vides the best util­i­ty for all con­stituents in­volved in the par­tic­u­lar is­sue.

Now, should I send that e-mail or not?

Ian Nar­ine is a reg­is­tered bro­ker with the Se­cu­ri­ties and Ex­change Com­mis­sion.

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