One of the most important things discovered during the development of behavioural economics is that people don’t always evaluate outcomes absolutely. Rather, they evaluate outcomes relative to a reference point. In a sense, investors who look at outcomes from the perspective of a reference point see those outcomes and, ultimately, their investments and portfolios through a distorted lens. This leads them to take risks when they should be more conservative and to act too conservatively when they should take a little more risk.

How does this work? A decision, in economics and finance, is depicted as a process of ranking alternatives and choosing the best one. To rank an alternative investment or portfolio requires an assessment of the outcomes (possible returns) and their likelihoods (probabilities). In orthodox economics, a so-called ‘rational’ decision-maker looks at outcomes and sees them as absolute gains or losses. A 10% positive return is a 10% gain. A 10% negative return is a 10% loss. The rational decision-maker sees this in a clear, undistorted way. Obviously, seeing the outcomes clearly is a pre-requisite for making optimal decisions.

Back in 1979 when Daniel Kahneman and Amos Tversky set down a key part of the foundation for behavioural economics, they made reference points the centrepiece of their prospect theory. This is a theory that attempts to describe the actual process that people apply when trying to rank or order alternatives. When considering outcomes, these decision-makers don’t necessarily see a 10% positive return as a gain. Nor do they necessarily see a 10% negative return as a loss.

At heart, this is a very human idea. When an investor looks at the 10% positive return generated by her portfolio she calls to mind the bragging neighbour who, just yesterday, boasted of the 15% he had earned on his portfolio. Against this 15%, which might become her reference point, a 10% positive portfolio return is not perceived as a 10% gain but a 5% loss! In a bad market, if the same neighbour had lamented his 15% loss, her 10% loss would be perceived as a 5% gain!

This distorted lens through which outcomes are perceived as gains and losses, not absolutely but against a reference point, is not simply a curious yet harmless artefact detached from choice. When investors find themselves in the domain of gains, they become more conservative and try to protect their gains. This could involve selling a winning investment too soon. On the other hand, they become more risk seeking in the domain of losses, taking more risk in an attempt to recover lost ground. This could involve doubling down on a losing investment.

Whether investors have made gains or losses definitely shapes their choices of what to do next. The interesting thing about reference points is that it is not absolute gains and losses that matter. Depending on the factors that shape the investor’s reference point—possibly including a pompous neighbour who has had a particularly good or bad outcome—the investor might see positive outcomes as losses and negative outcomes as gains. Gains and losses are a matter of perception. If this perception is processed through a distorted lens, the ordering of alternative investments and portfolios is upset and could end up a long way from the optimal decisions that would be made by the rational investor with a clear and undistorted view of the world.

Discussion Question

We have used the example of a neighbour’s investment returns as the source of an investor’s reference point. What are some other possibilities and how likely is it that investment decisions can be affected by the way that people perceive gains and losses?

Further Reading

Investor decision-making and behaviour is discussed in Chapters 6 and 7 of Financial Institutions, Instruments and Markets 9e. In Chapter 7, a brief introduction to behavioural finance is presented. Prospect theory is a core part of the theoretical foundation for behavioural economics. It appears to be able to explain many observed patterns of behaviour, including finance and investing behaviour.

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