Prospect Theory Through the Ages

“Riches do not exhilarate us so much with their possession as they torment us with their loss.” – Epicurus

“Men feel the good less intensely than the bad.” – Livy

“For most people, the fear of losing $100 is more intense than the hope of gaining $150. We conclude from many such observations that losses loom larger than gains and that people are loss averse.” – Daniel Kahneman

Irrational Overconfidence

In September, 2008, Dick Fuld, the Chairman and CEO of Lehman Brothers, traveled from his office on the thirty-first floor to Lehman’s trading floor to make an announcement. “I know some of you are unhappy with the performance of the stock,” Jared Dillian, a former Lehman employee reports in his memoir Street Freak. “And so am I. As you know, I own a lot of stock. And this has been just as painful for me as it has been for you. But we’re going to… get the stock back up to eighty-five bucks.” Fuld concluded on a reassuring note. “And don’t think I forgot about that one-fifty!” alluding to his long-term goal. Lehman filed for Chapter 11 bankruptcy protection on September 15th.

In September, 1998, precisely ten years before the collapse of Lehman Brothers, John Meriwether, the founder of Long-Term Capital Management, wrote a letter to investors announcing that “we see great opportunities in a number of our best strategies.” Long-Term’s equity plummeted from $2.3 billion to just a few hundred million dollars by the end of the month. The fund was liquidated two years later. According to Roger Lowenstein, author of When Genius Failed, “[Merriwether’s] analysis was devoid of any suggestion that anyone at Long-Term had made a mistake.”

Why does overconfidence sometimes flourish as our odds diminish? In nearly every corner of human life involving prediction—from poker tables in Las Vegas to corporate board rooms in Manhattan—we’d be better off if we were more realistic about our chances. But no. We double down. And we usually pay the price.

How You Make Money Will Influence How You Understand Luck

Imagine a genie visits two people. He gives the first, Brett, $100 million. The second, Mike, also receives $100 million. But the genie places Mike under a spell. Whereas Brett is aware that he received his fortune from the genie, Mike believes that he has spent the last twenty years of his life investing in the stock market. Through hard work, he has netted $100 million so far.

To an accountant Brett and Mike are the same. But Brett and Mike inhabit much different mental lives. Brett continues his life as normal, minus a few indulgences. He remains parsimonious, knowing that his fortune might vanish just as fast as it appeared. Mike continues to invest confidently. One weekend, however, an oil crisis in the Middle East erupts and a bubble in the tech industry bursts. Mike loses all of his money. Devastated, he commits suicide and destroys the lives of those who loved him.

On the path to $100 million, we should never judge the quality of a decision based on its outcome. If a hypochondriac buys 10,000 bottles of Advil and the world’s supply of ibuprofen suddenly runs out, we would never praise him for his foresight. Luck can play a large role in success, especially with respect to investing. There’s nothing inherently wrong with that, of course, except when we attribute a lucky result to our skill and intellect. Once that occurs, overconfidence and risky decisions flourish, and the chances of blowing up increases.

In his splendid book The Most Important Things: Uncommon Sense for the Thoughtful Investor Howard Marks offers similar advice. “We all know that when things go right, luck looks like skill. Coincidence looks like causality. A ‘lucky idiot’ looks like a skilled investor. Of course, knowing that randomness can have this effect doesn’t make it easy to distinguish between lucky investors and skillful investors. But we must keep trying.”

The Friendly Face Fallacy

Mike is a friendly, good looking middle-aged man who lives in Manhattan. He is having drinks with his friend Brent, a sharp thinking interlocutor.

Mike: Yesterday, a woman approached me asking for directions, which I happily provided. This is not the first time this has happened to me. People ask me for directions all the time! I must have one of those faces.

Brent: Mike, you fool. Don’t you see your illogical reasoning?

Mike: No. Please, explain.

Brent: How many lost people have looked at your face and decided not to ask you for directions?

Mike: How could I possibly know the answer to that question?

Brent: You cannot, which is my point.

Mike: I don’t follow.

Brent: True, people have asked you for directions. But it’s nearly impossible to know if  you “have one of those friendly faces” without first knowing how many people have looked at your face and turned the other way. Your judgment only considers success stories. It’s like trying to measure how good David Ortiz is at hitting home runs when your evidence is a highlight reel of every single one of his home runs. You need to account for how many times he didn’t hit a home run — all the strikeouts, ground outs, fly outs, singles, double, triple, etc.

Mike: I think I see what you are saying. But I still think I am at least above average.

Brent: Possibly, but unlikely. For that you would have to know what the average is in the first place. And I assume you don’t have data on how many times the average Manhattanite is approached for directions. Your intuition is not a good guide to determine that number.

Mike: So I am just an typical Manhattanite who is approached for directions as much as everyone else?

Brent: Most likely – but you’re an above average friend.

Mike: Thanks, Brent.

Brent: You’re welcome.


We Don’t See Non-Events

A wrecked car idles on the side of the road; four bottles of wine and two handles of whisky are in the back seat—the driver, an adult male, is unconscious in the front seat. The police arrive and call the paramedics. The situation looks bleak.

What do you make of this story? It’s difficult to avoid jumping to the intuitive conclusion without first considering the number of sober drivers who drive with alcohol. Every year, many cars that contain alcohol get into accidents. How many are caused by the driver consuming that alcohol? How many involve sober drivers who just happened to have alcohol?

The mind processes information fast, often generating a clean casual chain with just a few variables—Car crash. Alcohol. Unconscious driver. Drunk driving. But if we want to understand what happens in the world we must consider information that is not immediately apparent. This, however, is difficult.

In 1967, two psychologists presented participants with the following numbers: 147, 724, 947, 421, 843, 394. What do they have in common? Four is in each of them. Now consider another list: 239, 639, 865, 795, 261, 756. What do these numbers have in common? Four is in none of them. “What can we learn from this?” asks Rolf Dobelli in his book The Art of Thinking Clearly. “Absence is much harder to detect than presence.”

An analogous problem occurs when we attempt to understand business performance. If, for example, the price of a stock decreases while the CEO was on vacation, it’s intuitive to connect the two and conclude that the stock decreased because the CEO was on vacation. But this is the stuff of headlines. We must remember all those vacationing CEOs whose companies managed just well without them, even if such news does not make the front page.