Who Determines How Much You Earn?

Have you ever imagined you could control everything?

Economists once believed we could know everything about the market.

They proposed the efficient market hypothesis, which assumes investors are rational and stock prices reflect all available information.

Not all investors act rationally, but the hypothesis assumes their trades are random and therefore offset one another.

Not all irrational actions are random, but the hypothesis predicts rational traders who spot arbitrage opportunities in the market will eliminate the actions' impact.

We may also wonder how a rational actor makes decisions in the face of risk.

The expected utility theory offers a potential answer.

This hypothesis believes people tend to make choices based on expected utility.

Let's look at an example.

Suppose there are two possible scenarios.

One is that you have a 20% possibility of getting nothing and an 80% possibility of earning $100,000.

The other is that you have a 50% possibility of earning $60,000 and a 50% possibility of getting $90,000.

If we take the money earned as your utility, the two scenarios' utilities will be

80%*$100,000=$80,000 and 50%*$60,000+50%*$90,000=$75,000, respectively.

A rational person would definitely opt for the first one for its greater utility.

Ideally, this is what the market should look like.

Now, welcome to the real world.

The market may not be as efficient as we assume.

Sometimes we simply can't explain a price move.

And investors are not rational at all.

For example, you may have heard of Black Monday on October 19, 1987.

New York Times called it "the worst day in Wall Street history".

On that day, global stock markets plummeted, with the Dow Jones Industrial Average falling by 22.6%.

Even till today, reasons behind such a catastrophe cannot be fully explained.

Markets are complex, what's even more complex are those who trade in them.

Realizing this, Amos Tversky and Daniel Kahneman formulated the prospect theory.

They applied psychology to economics to explain how people make decisions under uncertainty.

Professor Kahneman was awarded the 2002 Nobel Prize for his work on this theory.

What does it tell us?

First, people have their own set of rules to weigh and value things.

After evaluating all the choices, they tend to pick the one with the highest perceived value.

The perceived value is closely related to reference points.

Historical data, expectations, or the situations of your peers can all be the reference.

For example, suppose you expect your house purchased at $100 would rise to $300 in a short time.

Then a current $200 bid would not be attractive to you.

Reference points can also be affected by gains, losses, and probability.

On the one hand, people prefer choices that can preserve their wealth.

On the other hand, they are willing to risk the chance to win rather than accept sure losses.

People also tend to overweight small probabilities.

This tendency explains why many will purchase lottery tickets and insurance, even though the likelihood of a big win or a disaster is very small.

Now you may get a sense of how complicated decision-making is.

The reality may be far from what it seems.

It's humanity's complexity that makes us unique.

Let's look at another example to see how framing may affect your choice.

One description is that the strategy's annualized rate of return in eight decades is 10%.

The other is that the strategy can turn your initial investment of $10 into $20,480 in eight decades.

Your perception of these two statements may be strikingly different.

But actually, they are the same option presented in two ways.

So how is an investment decision made exactly?

It is not easy at all.

Physiological factors, emotion, cognition, acquired information, information processing, reaction, and your understanding of human nature and yourself all matter.

Now we may finally answer the question raised at the beginning.

It is you who determines how much you earn.