How much money can you earn? It is determined by this factor.

Have you ever imagined that you could control everything?

Economists used to believe that we could understand everything happening in the market.

They proposed the efficient market hypothesis, which states that if investors are rational, stock prices will reflect all available information.

In fact, not all investors are rational. The hypothesis assumes that their trades are random, which cancels each other out.

However, not all irrational behaviors are random. Therefore, the hypothesis predicts that rational traders who identify market arbitrage opportunities will eliminate the impact of these behaviors.

We might wonder, how would a rational investor make decisions when facing risks?

Through Expected Utility Theory, we can get the answer. The theory believes that people tend to make choices based on expected utility.

Let's consider an example. Suppose there are two strategies for you to choose from.

The first one gives you a 20% chance of getting nothing, and an 80% chance of earning $100,000.

The second one offers a 50% chance of earning $60,000, and a 50% chance of earning $90,000.

If we consider the money earned as your utility, then the utilities of these two strategies are $80,000 for 80% * $100,000 and $75,000 for 50% * $60,000 + 50% * $90,000.

A rational person would definitely choose the first strategy because it has a greater utility.

Ideally, the market should be like this. However, what about reality?

The market may not be as efficient as we think. Stock prices often experience inexplicable fluctuations. Investors also often fail to remain rational.

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

The New York Times referred to this day as "the worst day in Wall Street history".

At that time, global stock markets plunged, with the Dow Jones Industrial Average falling by 22.6%.

What exactly caused this disaster? To this day, people have not come up with a reasonable explanation.

The market is very complex, but the people trading in the market are even more complicated.

Based on this, Amos Tversky and Daniel Kahneman proposed prospect theory.

They integrated psychology and economics to explain how people make decisions in uncertain situations.

In 2002, Professor Kahneman also won the Nobel Prize for this theory.

What does prospect theory tell us?

First, everyone has different standards for measuring things. After evaluating all choices, people tend to choose the option they believe has the highest value.

Value is closely related to the reference point. Historical data, expectations, or the situations of other people around can all be references.

For example, imagine you bought a house for $100 and expect the house price to rise to $300 in the short term. So, when someone offers $200 to buy the house at that moment, it would not be attractive to you.

The reference point is also influenced by benefits, losses, and probabilities.

On one hand, people prefer choices that guarantee the principal. On the other hand, rather than accepting certain losses, they would rather take greater risks to achieve potential gains.

People also tend to overestimate the likelihood of low-probability events. This pattern also explains why many people buy lottery tickets and insurance, even if the chance of winning a large prize or encountering a disaster is very small.

Making a decision is really complicated. It may be even more complex than you think! It is human complexity that makes us unique.

Let's look at another example to understand how framing can affect your choices. Suppose you are faced with two strategies:

One strategy is: hold for eighty years with an annualized return on investment of 10%.

Another strategy is that by investing just $10, you can get back $20,480 eighty years later.

Do they seem completely different? But in reality, they are the same strategy, just described differently.

So how do you make investment decisions? Actually, it's not simple at all.

Physiological factors, emotions, cognition, acquired information, how you process and react to information, as well as your understanding of human nature and yourself are all crucial.

Now we go back to the initial question. In fact, how much money you earn depends on yourself.