Are investors really risk adverse?

“Classical” financial theory is quick to answer with a strong “Yes”! All investors are seen risk adverse. However, in the Journal of Econometrica, back in 1979 Daniel Kahneman and Amos Tversky offered a different idea. In their theory known as Prospect Theory, Kahneman and Tversky mention how alternatives are perceived based on their framing, how gains and losses are evaluated, and how uncertain outcomes are weighted.

Interestingly enough, they found that people are risk-averse when there is a moderate to high probability of gains or a low probability of losses; they are risk-seeking when there is a low probability of gains or a high probability of losses.

Kahneman and Tversky also coined the term “Loss Aversion” as opposed to “Risk Aversion”. This is a big change in the way we view the mentality of each investor. This will explain why an investor holds on to a losing position and sells a winning position. The “pain” of selling a losing position can be seen as greater than the “joy” of selling a winning position.

Behavioural finance can really provide a very interesting insight into the investor’s mentality.

I love reading about behavioural finance. Are there any strategies that you think are effective in managing the psychological biases and emotions that can impact an investor’s decision-making?

Overall, I believe Technical analysis is very useful for this! In the publication, “Technical Analysis Modern Perspective” back in 2016, the CFA Institute Research Foundation, together with the CMT association wrote:

“Technical analysis is the study of data generated by the action of markets and by the behaviour and psychology of market participants and observers.”

Obviously, technical analysis also has several critics and there are definitely areas where it can improve. However, the study is based on real price movements that reflect actual behaviour from the market participants.

Although there is no particular strategy that works in every case (there never is) technical analysis offers several indicators. Broadly speaking, this can be seen as a study of market psychology, rationality, and irrationality included. :+1: