Riskalyze 101: What is Prospect Theory?

Want to know what makes Riskalyze tick? Today, we’ll discuss the behavioral finance framework that started it all—Prospect Theory.

Prospect Theory is an academic framework that won the Nobel Prize in Economics in 2002. It incorporates psychology into economic models and examines aversion to risk through a behavioral lens. Decades of academic research is empowering better decision-making today.

Historically, academic studies had taken a prescriptive approach, focusing on how decisions under uncertainty should be made. Prospect Theory instead took a descriptive approach, focusing on how people actually make decisions under uncertainty.

What made Prospect Theory different is that it discovered people treat gains differently than losses in two respects. First, individuals make choices to minimize losses, more than they gamble for possible gains. In one experiment, 80% of respondents preferred A) a certain gain of $3000 to B) an 80% chance of $4000 and 20% chance of gaining nothing. However, faced with the same two negative prospects, 92% of respondents preferred to gamble on an 80% chance of losing $4000 and 20% of losing nothing to a certain loss of $3000. In both cases, respondents chose the option with the lower expected value to avoid losses.

Riskalyze took this scientific framework out of academia and expanded it into a practical and effective tool for measuring true risk preference. Our Risk Number technology takes into account two important factors: A) an investor’s actual financial position, and B) what constitutes a “devastating” loss or an “acceptable” gain to them. When individuals make choices based on their actual financial position, it presents real consequences for the decision maker. This is one of the ways our risk assessment has utilized and improved the theory most effectively: it’s not just a dollar amount, it’s an amount that is both specific and meaningful to the investor.

Warren Buffett investing $100,000 of his fortune on a new tech stock would be modest, considering it’s just a small portion of his overall wealth. However, a family investing their entire net worth of $100,000 in that same security is willing to risk a lot more. A $100,000 loss for someone like Warren Buffet would hardly be considered “devastating,” and that’s where risk preference plays a vital role in keeping individuals invested for the long term.

Portfolio recommendations require quantitative measurements and as many questions as
are practical in order to gauge inconsistencies. Other risk questionnaires have used hypotheticals based on percentages, subjective questions such as, “What kind of car would you drive?” and other strategies that have no actual relevance to investors. At Riskalyze, we took award-winning behavioral finance principles and made them practical, giving advisors the tools, and the science, to empower fearless investing for the long term.

Want a deeper dive into the numbers behind Riskalyze? You can view the academic paper that reviewed our methodology here.

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