Explain how the reference point you pick decides whether an outcome feels like a gain or a loss.
You judge a money result as a gain or a loss from a starting line in your head. The final amount matters less than where that line sits, and how the result feels then shapes what you do next.
Hui Min invests in a company listed on SGX. In March, Hui Min buys 2,000 shares at S$2.40 each, S$4,800 in total (these are example figures). By June the price has fallen to S$1.80. Today it is S$2.10, so the 2,000 shares are worth S$4,200.
Hui Min says the investment is going badly. It is S$600 down, measured from S$4,800. A person below their starting line like this is more likely to hold and wait to "get back to even".
Someone else bought the same shares in June at S$1.80. Their 2,000 shares cost S$3,600, so S$3,600 is their zero. Today their holding is also worth S$4,200, and they say the investment is going well because it is S$600 up. A person above their starting line is more likely to sell and lock in the gain.
The two holdings are the same size and worth the same today. For Hui Min, the S$2.40 starting line may still decide whether to sell, hold or buy more.
The psychologists Daniel Kahneman and Amos Tversky published prospect theory in 1979. It describes how people actually choose between risky options. One of its central ideas is that people do not judge outcomes by the total wealth they end up with. They judge each outcome as a gain or a loss measured from a reference point, a starting line that feels like zero.
In the textbook model, S$4,200 is S$4,200, and what counts is what you can do with it from now on. Prospect theory says the same S$4,200 can feel like a loss to one person and a gain to another, depending on where each person's zero sits.
Kahneman shared the 2002 Nobel memorial prize in economics, partly for this work. Tversky died in 1996. The prize is not awarded after death, so Tversky did not share it.
Purchase price is the most common reference point in investing. It is one of several your mind may use:
A portfolio's highest-ever value, which can make an overall gain feel like a loss after the portfolio slips back from its peak. Last year's bonus, so a bonus of S$8,000 feels disappointing after one of S$10,000. What a friend or colleague earns, so a salary of S$5,500 can feel fine until a colleague mentions a higher figure. The first price you saw, such as a flat's asking price or a car's list price. What you expected, so a fund up 8% in a year feels poor when the market rose 15%, and a bonus of two months feels like a loss against rumours of two and a half months.
Darren, an employee, ran into the last of these. In January the company paid two months' bonus, more than the year before. The office rumour had been higher, and Darren spent a week annoyed. Against last year the money was a gain. Against the rumour it was a loss, and the rumour was the comparison Darren used.
Reference points also move. After a few months, people tend to reset their zero to the current level. This is the reason a portfolio that fell and stayed down can stop hurting, and a pay rise feels normal by the third payslip.
A different reference point changes how a result feels, while the result itself stays the same. This matters most when the feeling is about to lead to an action such as selling, holding or asking for more money.
Hui Min's S$600 paper loss exists only when measured against S$2.40, a price the market has no memory of. The company's prospects from today do not depend on what any investor paid for the shares.
You cannot stop your mind choosing a reference point. You can add a second, more useful one and decide with both in view. Start by noticing the number your mind keeps returning to, and write it down. Beneath it, write a more useful reference point. For an investment this is usually today's value in cash and your plan or target allocation. Then ask the decision question against that second line: if I had today's value in cash, would I buy these shares with it, and do they belong in my plan? Decide with that question in front of you. A yes means holding is consistent. A no means the purchase price is the only thing keeping you in.
Hui Min tried this. At the top of a page went "S$2.40, what I paid", the number that kept coming back. Underneath went "S$4,200 in cash, and my target allocation", followed by the question of whether the shares belonged there. Hui Min is not sure yet, which is fine. For the first time the question is about the company and the plan, and getting back to S$4,800 has dropped out of it.
The method works outside investing too. For a salary, a useful reference is what the job pays in the market and what your budget needs. One friend's number is a poor guide. For a bonus, use the amount you had planned around before any rumours started.
Lesson 2.2 looks at why losses measured from a reference point weigh so heavily. Before that, pick one investment of your own and find the number your mind keeps returning to when you think about it.
Pick one investment you hold. Write down the reference point you think about most, then one that would be more useful.
Junxiong-WFG Organisation is an authorised representative of AIA Financial Advisers Private Limited (Reg. No. 201715016G).