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3 Daniel KAHNEMAN and Amos TVERSKY, "Loss Aversion in Riskless Choice", (1991) 106:4 The Quarterly Journal of Economics 1039-1061. lacible 3, place du Commerce, bureau 501, Île-des-Sœurs, Verdun (Québec) H3E 1H7 Tél. : 514 767-4040 | Téléc. : 514 767-2845 www.iqpf.org Convention Poste Publication 41830524 According to prospect theory, every decision is made separately, without taking into account the full scope of the situation. Evaluation phase In this issue, we will focus on the evaluation phase, the second part of the decision-making process. After the information has been organized and simplified in the editing phase, the options are evaluated in their simplified form. The decision-maker grants a value to each possible outcome and weighs them based on the decision-making weight he gives to each one. The decision-maker then chooses the option that offers the highest perceived value. According to Prospect Theory: 1. We do not judge the value of each possible outcome based on its net value but rather on the basis of the change in value in comparison to a reference point. This reference point may be subjective. Important fact: The pain associated with a loss is higher than the pleasure associated with a gain in the same amount. 2. The decision-making weight granted to the possible outcomes does not reflect the rational evaluation of the probabilities applicable to each outcome. Rather, it is assigned using a subjective evaluation of the actual probability. In fact, in a situation of uncertainty, the decision- maker's value attribution process entails three characteristics: 3 • Dependence on the reference point The value attributed to a given option depends on its reference point. An investor who uses the purchase price of a share as her reference point may feel she is in a situation of gain, and yet if her reference point is the share value at the end of the previous month, she may feel she is in a situation of loss. • Loss aversion This bias leads the decision-maker to prefer a certain gain to the high probability of an even higher gain. This aversion to risk in a situation of gain is inverted in the situation of loss: the decision-maker will bet everything when there is even a faint probability of avoiding a loss. • Decreasing marginal sensitivity The smaller the amount in relation to the given reference point, the less it counts in the eyes of the decision-maker. So going $1,000 into debt hurts more than increasing an existing debt from $20,000 to $21,000. The probability that the event will occur influences the decision-making weight, but it is estimated subjectively, because it incorporates the desirability of the event and a host of other factors, such as the occurrence of a similar event in the recent past. Even when the decision-maker knows the real probability that an event will occur, the decision- making weight he uses in his evaluation does not generally reflect it accurately. As a financial planner, you have to be aware that landmark events in the news (such as market corrections) and events that affect the client's professional or family life (such as a loss on a security) influence the weight the client places on the available options. For example, major floods in recent years may lead someone to seek out insurance against this risk, even if flooding is improbable or even impossible where that person lives. The distortion between probability and decision- making weight is especially strong in the case of extreme probabilities (99% or 1%, for example). Financial planners should be more cautious of a client's reactions in the face of information of this magnitude and, whenever possible, avoid using extreme probabilities. You have probably already understood that our challenge is to guide our clients to make decisions based on their net value, even though this is generally not the reference point they themselves use to evaluate their options. Unfortunately, human beings naturally tend to make their financial decisions in silo. And that is what we will explore in our next issue, when we look at the other major theory in behavioural finance: mental accounting.

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