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AI and Prospect Theory: Understanding Risk and Reward in Investing

Updated: Feb 22

Artificial Intelligence (AI) has been an influential factor in various fields, and investing is no exception. Investors and financial institutions are leveraging AI technologies to better understand market trends, analyze patterns, and make informed investment decisions. In the context of investment psychology, AI can help us understand and apply prospect theory, particularly regarding predicting and responding to investors' attitudes towards risk. This article will explore how AI can facilitate the application of prospect theory in investing.

Understanding Prospect Theory

Before we delve into the relationship between AI and prospect theory, it is essential to understand what prospect theory is. Developed by Daniel Kahneman and Amos Tversky in 1979, prospect theory is a behavioral economic theory that describes how people decide between alternatives that involve risk, where the probabilities of outcomes are known. The theory states that people make decisions based on the potential value of losses and gains rather than the final outcome, and that people evaluate these losses and gains using certain heuristics.

The key insights from prospect theory that are relevant to investing include:

  • Loss Aversion: People feel the pain of losses more than they feel the pleasure of equivalent gains. In other words, the sorrow of losing $100 is more intense than the joy of gaining $100.

  • Certainty Effect: People prefer certain outcomes over uncertain ones, even if the uncertain outcomes may have a higher value.

  • Non-linear Probability Weighting: People tend to overestimate low probabilities and underestimate high ones.

These behavioral biases can have significant implications for investment decisions. For instance, loss aversion could lead an investor to hold onto a losing stock for too long, in the hope that it will rebound, instead of cutting their losses. Similarly, the certainty effect could lead to overly conservative investment strategies, while non-linear probability weighting could lead to undue risk-taking.

How AI Can Help Apply Prospect Theory

AI, with its ability to process vast amounts of data and identify patterns, can help us better understand and apply prospect theory in investing in several ways.

Predicting Investor Behavior: AI can analyze historical data on investors' behavior to predict how they might react under different market conditions. For example, machine learning algorithms can be trained on data about how investors reacted to past market downturns, identifying patterns that can be used to predict future behavior. These predictions can inform investment strategies, enabling financial advisors or robo-advisors to tailor their advice according to an individual's predicted risk tolerance and reactions.

Mitigating Behavioral Biases: AI can also help mitigate the behavioral biases identified by prospect theory. For instance, by identifying patterns of loss aversion in an investor's past decisions, AI could provide personalized advice to help them overcome this bias. This might involve strategies such as setting strict stop-loss limits to prevent holding onto losing stocks for too long.

Enhancing Risk Assessment: AI can improve risk assessment by incorporating insights from prospect theory. Traditional risk models often assume that investors are rational and make decisions based on maximizing expected utility. However, prospect theory suggests that investors' attitudes towards risk can be influenced by factors such as loss aversion and the certainty effect. AI can incorporate these insights into risk models, leading to more accurate predictions of market behavior.

Examples of AI and Prospect Theory in Investing

Let's look at some real-world examples of how AI is being used to understand and apply prospect theory in investing.

Robo-advisors: Robo-advisors like Betterment and Wealthfront use AI to tailor investment advice to individual investors. They gather data on an investor's financial situation, goals, and risk tolerance, and use this data to recommend a personalized investment portfolio. In this context, insights from prospect theory could be used to further tailor advice. For example, if an investor shows signs of loss aversion, a robo-advisor could adjust its recommendations to include investments with lower volatility or more guaranteed returns, thus aligning with the investor's behavioral tendencies.

Sentiment Analysis: Machine learning techniques such as Natural Language Processing (NLP) are being used to analyze large volumes of text data related to securities and crypto assets, allowing for quick and efficient sentiment analysis. This application of AI in investing can help predict market trends based on the sentiment expressed in social media posts, news articles, and other sources of public discourse. For example, the MLQ app from the company uses AI to analyze social media posts and provide a sentiment score, helping investors quickly gauge an asset's sentiment without having to read through thousands of tweets themselves​​.

News Sentiment Analysis: AI can also be used to analyze sentiment from news sources. With so many news sources available, it can be time-consuming and inefficient to read each source to gauge the overall sentiment. To solve this, the MLQ app provides a news sentiment score for the last 7 and 30 days for over 5000 US stocks, thus helping investors to make informed decisions​.

SEC Filings Sentiment Analysis: One of the most valuable applications of sentiment analysis for investing is analyzing SEC filings. AI can speed up the investment research process by enabling analysts to quickly review hundreds of filings in a short period of time. This can help identify which filings may contain interesting information and warrant further investigation​​.

ML-Based Return Estimates: Machine learning can be used to estimate returns, although this should never be relied upon solely. Instead, investors can use these estimates as a part of their research process. The MLQ app, for instance, provides ML-based estimates for both the probability of an up day or down day the following day, as well as multi-day estimates​​.

Stock Ranking Scores: Machine learning can also be used to rank stocks and provide scores based on various factors. The MLQ app, for example, takes in over 200 factors and signals, including fundamentals, pricing, technical indicators, and alternative data, and then uses an ensemble machine learning technique to analyze and rank stocks. This approach provides quantitative investors with a tool that can be used as a signal in investment models. A higher score might indicate a higher probability of outperformance in the next month, whereas a lower score might indicate a lower probability of outperformance​​.

In each of these examples, AI is used not only to analyze large volumes of data but also to predict future behavior based on past patterns. This ability to anticipate future trends and behaviors can be particularly useful when applied in the context of prospect theory, as it can help investors and financial advisors understand and predict how investors will react to different levels of risk and reward.

Investing is not just about numbers; it's also about understanding human behavior. Prospect theory provides a framework for understanding how investors make decisions under risk, highlighting the importance of factors such as loss aversion and the certainty effect. AI, with its ability to process vast amounts of data and identify patterns, can help us apply these insights in practical ways, from predicting investor behavior to mitigating behavioral biases and enhancing risk assessment. The end goal is a more nuanced and effective approach to investing, one that recognizes and responds to the complex interplay of risk, reward, and human behavior.


Interesting fact: During the housing bubble before 2008 global financial crisis, there was a widespread belief that home prices would continue to rise indefinitely, leading to excessive lending and a surge in housing-related investments. Investors were enticed by the potential for high returns, with the housing market serving as a reference point for many. As prices climbed, individuals became increasingly risk-seeking, seeking to capitalize on the apparent wealth accumulation. However, when the housing market collapsed, it triggered a chain reaction of financial turmoil. Many investors faced substantial losses as the value of mortgage-backed securities and other risky assets plummeted. Prospect Theory helps explain that the pain of these losses far outweighed the pleasure experienced during the period of inflated home prices, leading to panic selling, bank failures, and a global economic downturn. The 2008 financial crisis serves as a significant historical example where Prospect Theory's principles of risk aversion and loss aversion were observed. It highlights how investors' decisions can be influenced by biases, such as the underestimation of risks and the asymmetrical perception of gains and losses. Understanding these psychological factors is crucial for comprehending the complexities of financial markets and the potential for irrational behavior.

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