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Prospect Theory

Prospecting conjures up images of old-timers panning for gold in the Klondike – although the term is also used in geology and marketing. What we want to talk about today is the use of the term in understanding financial risk, and more precisely, risk tolerance.

Prospect Theory describes how consumers behave when faced with a choice of alternatives that involves risk, where the probable outcomes are known. While economists have a model, Expected Utility Theory, that concerns consumer preferences where the probable outcomes are unknown (uncertain). At one level consumer behaviour is irrational – regularly choosing sub-optimal options. However, at another level – risk appreciation – consumer behaviour follows well-worn paths.

Whether conscious of it or not, all consumers make an assessment of potential downside risks – loss aversion. Some concentrate on nothing else, while others quickly dismiss it and move on. However, it is a mistake to assume that risk tolerance is solely an emotional response – although, we accept that at times of high emotion consumers do weird things.

It is more correct to see risk tolerance as a fulcrum upon which individual consumers consistently rely. Academics portray risk tolerance as a willingness to bear fluctuations in spending in the long run. Consumers with a low risk tolerance will prefer a smoother spending pattern – more rainy-day funds and other contingencies just in case. This naturally extends to other financial decisions like fixing a mortgage rate and consistent investment returns – in other words, steady pay backs.

From MMPI’s point of view it is critical that we know the risk tolerances of each of our clients and that is where Prospect Theory comes into its own. The theory, which is backed up by many years of research, points to the questioning of consumers about their levels of risk aversion as the most effective way of measuring risk tolerance.

Questions like “You are the only income earner in the family and you have a steady long-term job guaranteed to give you and your family income every year for life. You are given the opportunity to take a new and equally good job, with a 50% chance it will improve your family income and a 50% chance it will not. Would you take the new job?  Your response will wholly depend on your “willingness to bear fluctuations in spending in the future.”

Research suggests that questions on spending variations, loss aversion and, intriguingly, self-assessment are accurate in determining the risk tolerances of consumers. This is of significant importance to MMPI because it allows us to objectively analyse the risk tolerances of our clients without relying on a subjective approach even though we believe we know our clients pretty well.

Our experience indicates that individual risk tolerances remain fairly constant over time but that consumers become much more risk averse in their senior years. However, getting clients to acknowledge when their senior years begin is highly contentious!

The following two scenarios are based solely on Prospect Theory. You might like to test your responses:-

  1. You are given €1,000 and you are asked to choose between:-
  • A certain gain of €500
  • A 50% chance to gain €1,000 and a 50% chance to gain nothing
  1. You are given €2,000 and you are asked to choose between:-
  • A certain loss of €500
  • A 50% chance to lose €1,000 and a 50% chance to lose nothing

Consumers choosing the certain outcomes in both scenarios have a low risk tolerance; those choosing the sure gain in 1. and the uncertainty in 2. have a moderate risk tolerance; and, you’ve guessed it, choosing both uncertainties indicates a higher level of risk tolerance. When you’ve worked through your responses – check your age! If you are in your golden years and you have a high level of risk tolerance we’d like to hear from you.

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