Consider the following pairs of choices:

#### Choosing from potential gains

Which would you choose?

- a gamble offering a 10% chance of making $9,998 and a 90% chance of making nothing; or
- a gamble offering a 88% chance of making $1,134 and a 12% chance of making nothing?

Most people would chose the **second** gamble. They prefer a high probability of making less money over a long-shot on making a lot of money.

This preference holds even though the expected value of the long-shot is higher:

- 10% x $9,998 = $999.80
- 88% x $1,134 = $997.92

#### Choosing from potential losses

Which would you choose?

- a gamble offering a 5% chance of losing $19,998 and a 95% chance of losing nothing; or
- a gamble offering a 93% chance of losing $1,074 and a 7% chance of losing nothing?

Most people would chose the **first** gamble. They prefer a small chance of a huge loss to a highly likely small loss.

Again, this preference holds even though the expected value of the long-shot is a larger loss:

- 5% x ($19,998) = ($999.90)
- 93% x ($1,074) = ($998.82)

#### What does this mean?

From the above examples, we see that the average person wants the sure thing when the payoff is a gain, but would prefer to gamble when looking at a loss.

These preference manifest themselves in investor behavior.

When sitting on a capital gain, the average investor feels an urge towards risk aversion. He will want to lock in his gain by selling the stock.

Let’s imagine something very positive happens to a company and the stock moves upward. In a perfect world, the stock would move upward the exact amount justified by the positive event. But in practice, a wave of stockholders will sell reflexively into the stock’s price advance. This selling will suppress the stock price somewhat, for a time keeping it below the price that fully reflects the positive development. An enterprising investor may be able to buy the stock *after* the positive news and ride it up to the new fair value.

In contrast, when sitting on a capital loss, the average investor will become a risk taker – he will hang on to his shares.

Consider a company, the fortunes of which are in decline. The stock is falling. Faced with the horror of taking a loss, the average investor promises himself that he will sell when the stock gets back to what he paid for it. His refusal to take action means fewer sellers in the market; fewer sellers means less downward pressure on the stock price, so that the current stock price does not fully reflect (yet) the company’s poor fundamentals. Thus, according to prospect theory a stock in a downward spiral is likely to continue falling.