The Rich Uncle: Prospect Theory and Investing (from the Foreword of Social Media Strategies for Investing)

Imagine that a wealthy and elderly uncle invites you for a visit. Over lunch, he reveals that he plans to leave you a considerable sum of money in his will. There is a catch, however. He will either leave you $1 million, or you can flip a coin with him. If you win the toss, you get $3 million. If you lose, you get nothing. Your elderly relative has developed a playful streak in his old age!

If you are like most people, you would choose the $1 million “sure thing.” But consider the other option for a moment: It is actually worth much more than $1 million because a 50/50 shot at $3 million is “worth” $1.5 million. Still, that $1 million “bird in the hand” would set you up for life. Thanking your uncle for his generosity, you part ways, happy that your financial future is finally secure. His coin, meanwhile, stays safely in his pocket. Imagine the regret you would feel, if you were to lose the coin toss and walk away with nothing.

This story, anchored in the Nobel Prize–winning concept of “prospect theory,” reflects an important lesson about how humans make financial decisions: It’s not just about the money. If it were, you’d flip the coin and take your chances. Instead, we make constant tradeoffs that aim both to maximize our happiness and to minimize future handwringing over our decisions. Losses — even if merely imagined — weigh heavily on our psyches and profoundly inform our choices.

Happily, technology is a highly useful tool for managing this never-ending tightrope of difficult financial decisions, both big and small. If you are buying a house, you can check numerous real estate websites to evaluate your options. Considering the purchase of a new car or television? An Internet search will help you find the best price and let you read in-depth product reviews. Perhaps you are out on the town with friends. With your smartphone, you can check into every eatery nearby, find a highly rated one, and even book a table. In each case, technology allows you to maximize your choices and — just as importantly — minimize potential regret.

For all the clear benefits of technology in your daily lives, chances are very good that you don’t leverage it effectively, when it comes to investing. But why not? Part of the answer is obviously that nagging fear of regret. We worry that we’ll make the wrong decision and lose part of our hard-earned capital with an ill-considered investment from a dubious source. A larger issue, however, is that the Internet is a “firehose” of information, and it is hard to know where to begin, and whom to trust.

When faced with an overwhelming array of choices, we tend to revert to the familiar ones even if they aren’t the best options out there. In other words, despite a dizzying array of twenty-first century tech-enabled information resources, we tend to act on a limited menu of choices. To effectively balance the wealth of information available to us with our natural avoidance of regret, we need a clear and consistent strategy. Without such a playbook, our psychological tendency toward regret would be a permanent and unwelcomed third wheel.

Consider the topic of this book: social media and the investment process. Chances are that you know something about both, but they are difficult and complex topics. Keeping up with all the latest Internet outlets for individual social expression is a full-time job, and there seem to be new offerings every week. And investing is never easy, with the last decade’s volatility only adding to the confusion.

A marriage of these two subjects of social media and investing might seem like an unholy alliance. But technology marches forward, and we must follow in its path. The good news is that you already have the skills and, if you’ve read this far, you clearly have the interest to succeed in this new challenge. 

The investment process in light of social media is an important topic for individual investors to understand. Even if you only choose to use a fraction of the contents of this book for your investment decisions, you will be better off for it. Institutional investors — “big money” hedge funds, mutual fund managers, pension funds, and very wealthy individuals — constantly scramble to leverage every possible advantage and reach their goals. Using social media is the single hottest topic for many of them at the moment. How — not if — they choose to incorporate this technology into their investment processes will play an increasingly important role in how they value securities in coming years. As an investor you need to understand these changes too, and that is the purpose of this book.

In the end, investing is simply a microcosm of our life’s journey. We constantly make choices between two scarce resources: time and money. We proactively seek happiness while seeking to minimize regret. At the same time, the rules are always changing, and we have to change with them. Using every resource at our disposal, guided by those whom we trust, is the best way to navigate the investment landscape. The use of social media in investing is now part of the capital markets, so it must be on your roadmap.

After all, wouldn’t you like to be that capricious rich uncle one day?

- Nicholas Colas, Chief Market Strategist