Did you know people may be impulsive, emotional, or myopic about their own investments, but usually not about the investments of others? Why is that?
If you were offered a gamble where you had a 50% chance to lose £100 and 50% to win £200, would you accept it? Chances are that you would reject it. This gamble is now known as the famous Samuelson’s gamble, where Paul Samuelson offered the above gamble to a colleague. His colleague declined to play it once, however, he commented that he would play the gamble if it would be repeated a hundred times.
This is prospect theory. It tries to describe the way people will behave when given choices which involve probability. Prospect theory assumes that individuals make decisions based on expectations of loss or gain from their current relative position. An important element of prospect theory is the idea that individuals are particularly averse to losing what they already have and less concerned to gain. In other words, “Losses loom larger than gains”
Given a choice of equal probability, individuals would choose to preserve their existing wealth, rather than risk the chance to increase wealth.
By understanding how your emotions drive your decisions, you are better able to manage biases.