David Letterman on Prospect Theory

I stumbled across this gem from the NYT recent interview with David Letterman:

More earnestly, he added: “Maybe life is the hard way, I don’t know. When the show was great, it was never as enjoyable as the misery of the show being bad. Is that human nature?”

Yep, it is definitely human nature.  And it has implications for our investment behavior as well.  From then entry on Prospect Theory in Investopedia:

According to prospect theory, losses have more emotional impact than an equivalent amount of gains. For example, in a traditional way of thinking, the amount of utility gained from receiving $50 should be equal to a situation in which you gained $100 and then lost $50. In both situations, the end result is a net gain of $50.

However, despite the fact that you still end up with a $50 gain in either case, most people view a single gain of $50 more favorably than gaining $100 and then losing $50…

…Prospect theory also explains the occurrence of the disposition effect, which is the tendency for investors to hold on to losing stocks for too long and sell winning stocks too soon. The most logical course of action would be to hold on to winning stocks in order to further gains and to sell losing stocks in order to prevent escalating losses.

When it comes to selling winning stocks prematurely, consider Kahneman and Tversky’s study in which people were willing to settle for a lower guaranteed gain of $500 compared to choosing a riskier option that either yields a gain of $1,000 or $0. This explains why investors realize the gains of winning stocks too soon: in each situation, both the subjects in the study and investors seek to cash in on the amount of gains that have already been guaranteed. This represents typical risk-averse behavior.

David Letterman perfectly articulated a condition that affects most of us: we feel the impact of loss and pain to a greater degree than we feel the impact of an equivalent amount of gain or joy.  Left unchecked this disposition effect creates all kinds of problems in our investing behavior.  We hold on to the losers because if we don’t actually sell a loser then we won’t have have to admit that the trade didn’t work and we think we are avoiding some measure of pain.  And the winners, well we sell them as fast as possible to avoid seeing those gains evaporate (even if it means missing out on the continuation of that trend).

The only problem with giving in to the disposition effect is that it leads to very poor investment results.  See Jim O’Shaughnessey’s What Works on Wall Street.

So what can be done?  As with most things in life that work, the solution is not complicated.  It only requires great discipline.  It is for this very purpose that adherence to models (which enforce discipline and helps combat the disposition effect) is front and center in the Dorsey Wright experience.  It may never become “easy” to take the trades that a well-designed model provides, but I can attest to the fact that it is easier and I believe more profitable than trying to navigate the markets without models.

The relative strength strategy is NOT a guarantee.  There may be times where all investments and strategies are unfavorable and depreciate in value.

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