A few years ago (seems like a few to me (2012/01/25), I posted a paper comparing the body of work Hal Forsey and I developed (Post Modern Portfolio Theory) with Prospect Theory, developed by Daniel Kahneman and Amos Tversky. An excerpt from that posting is reprinted below because parts of that article have now become an integral part of a new theory I am developing with Dr Jeremy Sosabowski, CEO of AlgoDynamics and Dr. Ronjon Nag at the R42 AI Institute at Stanford. It is tentatively called, The “Tipping Point Theory”.
In chapter 26 of “Thinking Fast and Slow” Daniel Kahneman points out some of the flaws in Prospect Theory, starting with when the reference point is assumed to be zero He goes on to say, “Prospect theory has flaws of its own, and theory induced blindness to these flaws has contributed to its acceptance.” That led him to posit a two system approach to understanding the decision making process of human beings. System 1 deals with intuitive responses that are automatically and effortlessly arrived at. System 2 is concerned with the deliberate and effortful mental activities associated with quantitative reasoning. I like to think of our approach to investing as being associated with System 2.
The purpose here is to point out how we attempt to incorporate some of the findings of K&T in our strategy. K&T pointed out that classical utility theory lacks a reference point from which to evaluate gains and losses. They said the reference point may be an outcome to which one feels entitled (e.g., retirement income). We call this reference point the Desired Target Return® or DTR®. Returns below the DTR incur risk of not accomplishing the goal. Returns above the DTR are the gains in excess of what is needed. Prospect Theory implies losses loom larger than gains. We agree (see Figure 2).
The S shaped utility function of prospect theory in Figure 1 indicates investors are risk averse to returns above the DTR and become risk takers for returns far below the DTR.
This may well be the way people behave but it is contrary to one of the oldest strategies on Wall Street, “Ride your gains and cut short your losses.” People like Bernard Baruch used this simple rule of thumb to overcome some of the System 1 responses that Khaneman uncovered. The foolishness of ignoring a small probability of a disastrous outcome can be illustrated by considering the small probability of a parachute not opening. Something akin to considering only the probability of a mechanical failure while ignoring the magnitude factor of breaking every bone in your body after plummeting to earth is foolhardy at best and should never be offered to clients as a low risk strategy.
Peter Fishburn proposed the utility function in Figure 2 . We view it as a System 2 type theory of choice.
Figure 2 seems a more sensible way to behave than Figure 1. Investors are viewed as risk neutral for achieving returns above the DTR. They like the notion of acquiring greater wealth than they need; yet they are risk averse to losses that result in failure to achieve their goal.
Then Hal and I worked with two professors at Groningen University to develop a performance measure that captured that concept and corrected the “faulty parachute” type of reasoning Khaneman cited above with the ratio shown in Figure 3
Recent findings in neuroscience provide evidence that a System 2 approach that captures what investors intuitively want but don’t know how to quantify should be superior to asking them to fill out a risk tolerance questionnaire they don’t understand. It seems that the part of the brain just inside our temples, called the dorsolateral prefrontal cortex is involved with events in the outside world that require explicit, analytic and rule based reasoning. The part of the brain behind our forehead deals with emotions, whether something is good or bad, and is called the medial prefrontal cortex. Preference questionnaires require the wrong part of the brain, the emotional part, to deal with events in the outside world (like portfolio management) instead of the rational part of the brain.
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What do you know when you know that? People behave foolishly when making investment decisions and they don’t learn from their mistakes. So, what do you do with that information? When and what do you buy or sell?? These are questions that behavioral finance does not answer…but Tipping Point Theory does.