Via DataTrekResearch.com, Whenever equity markets get choppy we spend some time reconsidering Prospect Theory, the first behavioral finance concept to ever win a Nobel Prize. Here is how it works through the lens of a simple example: Suppose a stranger offers you a choice between a coin flip gamble or a sure thing. The coin flip will either pay $100 or zero, depending on whether you call the toss correctly. The sure thing is $40 – two crisp $20 bills in your pocket – with no risk to you. The coin flip is clearly the better bet; its expected value is $50 (50% chance of $100, 50% chance of zero). That’s more than the $40 sure thing, and everyone offered this choice should go for the gamble. The funny thing is many people choose the sure $40, even though it is a suboptimal choice. I have posed this choice to many groups of investment professionals over the years. Somewhere between 20-40% want the certain payoff. When I ask them why, the responses are usually some form of expected regret. “I would feel stupid if I lost the coin toss” is a common explanation. In one sense, that’s the “prospect” in “Prospect Theory” – the anticipation of future feelings when assessing outcomes with different probabilities – but there is more to the construct than that. Specifically: “People underweight outcomes that are merely probable in comparison with outcomes that are obtained with certainty.” (From the original Kahneman & Tversky paper, link below). Humans “feel” a loss more acutely than a gain of a similar amount. Losing $100 on a poker hand generates more unhappiness than winning $100 makes us happy. We also tend to overweight the importance of low probability events (which is why lotteries are so popular, for example, or why we fear market crashes). Prospect Theory neatly explains why the old Wall Street adage “Stocks take the stairs on the way up, but the elevator on the way down” is so accurate.Here is how that works: Since 1970, years when the S&P 500 posts a negative total return have averaged a drawdown/loss of 14.9% (9 years in total). Over the same timeframe, the average S&P return for all positive years is 18.0% (29 years). The average total return over the 1970 – 2017 timeframe is 11.8%. In other words: investors face the possibility of a 15% annual loss to make 12% (on average) or 18% (upside case), payoffs so similar that they naturally get twitchy when stocks begin to falter. Forget for a moment that US equities give investors much better odds than a coin flip, since up years outnumber down years 3:1. And that those up years compound to generate real wealth creation over time (although this obviously works in reverse with sequential down years). That investors can overlook those critical points is a testament to the outsized power of fearing loss rather than anticipating gains, as Prospect Theory clearly shows. Three points about why all this matters right now: #1. With the S&P 500 down 13.0% from its late September highs and 4.9% lower on a year-to-date basis, the fear of more losses to come are swamping investor confidence in the possibility of future gains. Prospect Theory explains why: losses “hurt” more than equivalent gains. #2. While there may be technical reasons for the recent volatility, ranging from hedge fund redemptions to year-end portfolio reallocations out of stocks, those don’t matter to investor psychology just now. There are no asterisks in Prospect Theory – it always works the same way. #3. Both Prospect Theory and our own analysis points to more volatility to come. One would think investors would be more patient, given the S&P 500’s +170% return since 2010. But now that markets are showing losses, the asymmetry of loss aversion versus gain seeking is the dominant theme. Our own work on market returns after down 4% days tells the same story: a year later stocks tend to be higher, but the first few months after such an event are notoriously difficult. Summing up: as much as we would like to end this note with an upbeat message, the reality of investor risk-aversion is too much on display to say “buy them right here”. Long time readers know we do our best to remain constructive on US stocks. But the near term will remain very choppy indeed. * * * Download Prospect Theory Paper here.