You will be able to explain how the reference point you choose decides whether an outcome feels like a gain or a loss.
In March, Hui Min bought 2,000 shares of an SGX-listed company at S$2.40 each, S$4,800 in all. By June the price had fallen to S$1.80. Today it's S$2.10, and her holding is worth S$4,200. Ask her how the investment is going and she'll say badly, because she's S$600 down. Ask someone who bought the same shares in June and they'll say well, because they're S$600 up. The shares, the company and today's price are identical. The only difference is where each person started counting.
In 1979 the psychologists Daniel Kahneman and Amos Tversky published prospect theory, a description of how people actually choose between risky options. One of its central ideas is that people don't 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.
The textbook model says S$4,200 is S$4,200. What matters is what you can do with it from here. Prospect theory says that S$4,200 feels like a loss to Hui Min, because her zero is S$4,800, and a gain to the June buyer, because their zero is S$3,600. The feeling then drives what each of them does next. Hui Min is more likely to hold on and wait to "get back to even". The June buyer is more likely to sell and lock in the gain.
Kahneman later shared the 2002 Nobel memorial prize in economics, partly for this work. Tversky had died in 1996 and the prize isn't awarded after death.
The purchase price is the most common reference point in investing, but it's far from the only one. People measure against all sorts of numbers:
the highest value a portfolio ever reached, so a balance that is up overall still feels like a loss 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 pay rise feels small next to theirs the price you saw first, such as a flat's asking price or a car's list price what you expected, so a bonus of two months feels like a loss when you'd heard rumours of two and a half
Darren had that last experience in January. His company paid two months' bonus, which was more than he'd received the year before. He spent a week annoyed, because the office rumour had been higher. The money in his account was a gain against last year and a loss against the rumour, and the rumour won.
Reference points also move. After a few months, people tend to reset their zero to where things now are. That's why a portfolio that fell and stayed down can stop hurting after a while, and why a pay rise feels normal by the third payslip.
Because the zero decides the feeling, you can change how a result feels without changing the result. A fund that rose 8% in a year when the market rose 15% feels like a failure against the market and a success against cash. A salary of S$5,500 feels generous against your last job and stingy against your friend's.
This matters most when the feeling leads to an action. Hui Min's S$600 loss is a loss only on paper, and only against a price the market has no memory of. The company's prospects from today don't depend on what she paid. Yet the S$2.40 starting line may decide whether she sells, holds or buys more.
You can't stop your mind choosing a reference point. You can add a second, more useful one, and then decide with that one in front of you.
For an investment, the most useful reference point is usually today's value and your plan. Ask: if I had S$4,200 in cash today, would I buy these shares with it? If yes, holding is consistent. If no, the purchase price is the only thing keeping you in. For a salary, a useful reference is what the job pays in the market and what your budget needs, rather than one friend's number. For a bonus, it's the amount you'd planned around before the rumours started.
Hui Min tried this. She wrote "S$2.40, what I paid" as the number she kept thinking about. Underneath she wrote "S$4,200 in cash, and my target allocation", and asked whether these shares belonged there. She wasn't sure yet, which was fine. For the first time the question was about the company and her plan, rather than about getting back to S$4,800.
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.
For one investment you hold, write the reference point you think about most and one more useful one.
Junxiong-WFG Organisation is an authorised representative of AIA Financial Advisers Private Limited (Reg. No. 201715016G).