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!