Prospect Theory
A core finding in behavioral finance tells us something important about how to structure a portfolio
Prospect Theory was developed in 1979 by Daniel Kahneman and Amos Tversky. It is famous because it took down one of the longstanding and fundamental pillars of economics—the concept that individuals will always seek to "maximize utility."
Contrary to the economics textbook, Kahneman and Tversky found that people look at potential losses and potential gains differently. Most importantly, for example, people dislike a $1 loss more than they enjoy a $1 gain. In fact, they found that it takes a gain of about $2 to offset a loss of just $1. In other words, people really hate losses.
How does this apply to your finances? Frequently people will ask me why they should own bonds if they're not even paying enough to keep up with inflation.
My answer is always the same: You shouldn't own bonds to make money; instead, bonds are there to help you avoid losing money. When the stock market declines, bonds help you manage through that period. In other words, your allocation between stocks and bonds might not stand up to the scrutiny of a calculator, but it should stand up to the reality that Prospect Theory teaches us—that protecting against losses is even more important than driving for further gains.