Utility Theory

SEM Portfolio Manager, Jeff Hybiak explains utility theory, an important financial concept that is often misapplied in the real world. This can often lead to "irrational" financial decisions. He uses the two situations from our recent survey to walk through what utility theory is and how SEM provides a way to combat this bias.

Traditional financial theory is based on a belief the participants in the economy can correctly measure a concept called "utility." Essentially, economic utility is the value you would place on something. The theory assumes all participants would rationally calculate the utility of every decision and thus always choose the one that provides the greatest value. 

The choices posed in the survey are simple illustrations of how that is often not the case.

Situation 1

The expected value of the first choice is $5 million (100% x $5 million)

The expected value of the second choice is $6.95 million

(89% x $5 million) + (10% x $25 million) + (1% x $0)

Therefore, you should ALWAYS prefer the second choice* 

Situation 2

The expected value of the first choice is $550,000 (11% x $5 million) + (89% x $0)

The expected value of the second choice is $2.5 million (10% x $25 million) + (90% x $0)

Therefore, you should ALWAYS prefer the second choice*

*According to traditional financial theory

What do people actually do?

What most people chose in situation 1 was the first choice -- a guaranteed chance of winning versus a very small gamble to win even more. In situation 2, most people didn't mind taking a 1% greater chance of losing if it meant gaining more money. According to economists, you are irrational if you wouldn't gamble in the first situation, but chose to gamble in the second situation.

What if I did this?

Do not feel bad if you did not make the "correct" choice. Professional statisticians, those whose career is based on their ability to correctly apply statistical theory, overwhelmingly miscalculated the "utility" of these situations. Even worse, professional economists also chose inconsistently. If those who should know better answered incorrectly, how are "normal" humans supposed to get this right all the time? It gets even harder when we are faced with not so simple calculations of "utility."

Is it bad to be irrational?

Unlike economists, psychologists and sociologists have always assumed an "irrational" participant. This term is not an insult, but simply and understanding that few humans can consistently make decisions that are 100% rational, 100% of the time. Our mood, our current financial situation, our energy level, and many other factors contribute to our ability to consistently calculate the "utility" in any situation. Being irrational is part of being human!

How can SEM help?

At SEM, we follow a behavioral approach that is designed to adapt to each individual's personality. The choices you must make when investing are far more difficult than this simple illustration, making it nearly impossible to remain 100% rational, 100% of the time.

Want more information about SEM and how they can help? Click here!

© 2016-19 Strategic Equity Management, Inc. dba SEM Wealth Management. Site created by Courtney Hybiak.

This site is for INFORMATIONAL PURPOSES ONLY.  Investing in the stock or bond markets involves risk and may not be suitable for all investors. Before making any investment decisions you should carefully consider your investment objectives, level of experience and risk appetite. The possibility exists you could sustain a loss of some or all of your initial investment and therefore you should not invest money you cannot afford to lose. You should be aware of all the risks associated with your investments and seek advice from an independent financial advisor if you have any doubts. All investments involve risk including those managed by SEM Wealth Management (SEM).

 

​Any opinions, news, research, analysis, prices or other information contained on this website, by SEM, its employees, partners or contributors, is provided as general market commentary and does not constitute investment advice. SEM will not accept liability for any loss or damage, including without limitation to, any loss of profit, which may arise directly or indirectly from use of or reliance on such information.

The use of this website constitutes acceptance of our user agreement. Past performance is NOT indicative of future results.

 

There is no representation made as to the future results of SEM’s programs or if they will be profitable.

For additional information on the author and SEM, please see our DISCLOSURE DOCUMENT (ADV Part 2)

Privacy Policy:

Our client's privacy is important to us.  Under federal law all clients have a right to know what information is being collected about them and how that information will be used.  SEM’s goal is to protect their privacy.  To conduct regular business, we may collect nonpublic personal information from sources such as:

    • Information reported by clients or their advisors on applications or other forms provided to us by them

    • Information about transactions with us, our affiliates, or others

However, SEM does not share or disclose any nonpublic personal information about its current or former customers, except as permitted by law.  All information will remain confidential.

 

Information Safeguarding
SEM will internally safeguard all nonpublic personal information by restricting access to only those employees who provide products or services to you or those who need access to client information to service your account.  In addition, we will maintain physical, electronic and procedural safeguards that meet federal and/or state guidelines to guard any nonpublic personal information.

This policy is provided in accordance with Title V of the Gramm-Leach-Bliley Act and Regulation S-P.