MARK RIEPE: I'm Mark Riepe. I head up the Schwab Center for Financial Research, and this is Financial Decoder, an original podcast from Charles Schwab. It's a show about financial decision-making and the cognitive and emotional biases that can cloud our judgment.
There's a song by folk legend Arlo Guthrie called "The City of New Orleans." It's most famous for its refrain of "Good morning America, how are ya?"[1] The song's about riding a passenger train from Chicago to New Orleans, and there's another lyric that caught my ear last night before I sat down to record this podcast. It goes, "Dealin' card games with the old men in the club car, penny a point ain't no one keepin' score.."1
I got me thinking about how in we, especially our financial lives, without even thinking about it really, we actually do keep score. For example, say you want to buy a car. You put away some money with each paycheck. You keep tabs on when you'll have enough money to buy that car. The act of saving for a goal involves keeping score in the form of enumerating how far I am from my goal. That's a simple example.
A more complex example is when we check on the performance of a single stock in our portfolio. If the performance of the stock is ahead then we're in some sense winning. And if it's behind then in some sense we feel like we're losing. But we need to stop and ask ourselves: winning or losing relative to what?
Let's say you have a stock that you bought at $100 per share, and recently it hit an all-time high at $180 per share. But you didn't sell, and it dropped back to $125. Now you're holding onto it. Are you winning or losing? Compared to your purchase price you're winning because you've got an unrealized profit of $25. But compared to the all-time high when you could've sold at $180, you've got a loss of $55. Depending on how you look at it, you either feel good or feel lousy.
My point is that how we keep score matters because it influences the decisions we make. In other words, the way we score our activities will translate into emotions and ultimately affect our decision making.
But right now, it's time to talk to my guest, who has studied loss aversion and related concepts in the laboratory of sports. He is a world-class researcher who has looked at golf and basketball through the lens of some behavioral finance principles. In other words, he's analyzed how pro golfers and basketball players are prone to some of the same biases that might plague you and me in our financial lives.
There's a reason he's looked at sports. Sports provide a "clean" environment to test theories. Sports have rules which eliminate some of the messiness of real life. They also offer vast data sets that can be analyzed. Experiments are complicated to set up and can be kind of artificial, but sports are real in the sense that real people are making real decisions that can have huge amounts of money at stake. Sports can be a great option to see how various theories play out.
And the researcher who did all this is Daniel Stone. He's an associate professor of economics at Bowdoin College and chair of the economics department. He's been at Bowdoin since 2012 and teaches courses on microeconomics, behavioral economics, information and uncertainty, and game theory. His research covers a range of topics, including belief formation, political media, and polarization.
It's a real pleasure to welcome him to Financial Decoder.
So Dan Stone, professor of economics here at Bowdoin College. Dan, thanks for being here today.
DANIEL: Thanks so much for having me.
MARK: You've done some really interesting work on applying behavioral economic concepts to both golf and college basketball. Maybe before we kind of dive into the studies, could you tell us a little bit about how you found your way into behavioral economics and teaching?
DANIEL: Yeah, sure. So I am not a person who grew up thinking that I wanted to be a professor. I kind of stumbled into becoming a professor. I tried a couple of things after grad school. I did AmeriCorps. I did consulting and wasn't sure what to do. So I wanted to learn how to understand the world better, and so I gave an econ PhD program a shot and ended up really liking research and teaching there.
And then once I was there, there was the big question of what type of econ to focus on. And I have always been someone who's been very interested in this question of why do people do the seemingly dumb things that they do? How can people make better decisions? How can we live better lives? And that's what behavioral econ is mostly about, right? So behavioral econ is in large part the sort of study of mistakes and foolish behavior by economists. It's not just about mistakes and foolish behavior, but a lot of it is. And so that was right up my alley because I really had the goal of making some contributions to help people to understand the way to make better decisions.
Then I got into using sports data to study behavioral econ because it's pretty good data. But I'll hold off on saying more about that for the moment.
MARK: Well, I think the nice thing about sports is it's just a way of, in a very vivid way, illustrating some of the power of these different analytical techniques. It's not that golf and college men's basketball is all that important, but it's more the other applications of this coming up in people's daily lives that is ultimately what, certainly what we're trying to accomplish here, at least in the financial realm.
So maybe I'll start with the golf study, and you were using real data from real golfers and using prospect theory to explain how the golfers were going about playing their rounds. So before we get to the study a little bit, maybe just explain what prospect theory is and what really drives it and why it's so important.
DANIEL: Prospect theory is a theory of choice under uncertainty that was proposed by the psychologists Daniel Kahneman and Amos Tversky in the 70s. And this was really the work that…the main work that they ended up winning a Nobel Prize in economics for. And these two guys, along with Richard Thaler, were basically the founders of behavioral economics, and prospect theory was a key part of that.
So prospect theory assumes that people focus on changes or differences in their outcomes as compared to what are called reference points when making decisions. So they don't think about how well off they are overall. They don't take a very big picture perspective. They think, "Am I up a little bit? Am I down a little bit? Am I up a lot or down a lot compared to a reference point?" A reference point is just some point of comparison. It's often an expectation. Sometimes it's often the status quo.
So, if you've got a new job—or you just applied for a job—you got the offer, you don't know what they're going to pay you yet. You know, if you expect the salary to be whatever, expect $100,000, that's your reference point. If they offer you $95,000, then standard economics, traditional economics would assume it's $95,000. It is what it is. But prospect theory says you would consider that to be a $5,000 loss because it's $5,000 below your reference point, your expectation.
So one big difference between prospect theory and standard or neoclassical econ is that prospect theory assumes people really focus on these differences versus their expectation or reference point.
And there are some other important elements. There's two others that I should mention. One is that losses, when you suffer a loss versus the reference point, it's much more powerful than when you beat the reference point by a little bit. So losses are of course painful, but prospect theory assumes that losses are about two or three times as powerful as gains feel good. So that's called loss aversion.
And the other element that I should mention here is that prospect theory also assumes that as you move further and further from the reference point, you become sort of numb to additional distance from the reference point. So when you win $100, it feels great. If you win another $100, that doesn't do as much for you. And that's sort of consistent with a standard or traditional notion of diminishing marginal utility. But what's different in prospect theory is that it assumes that you also become numb to increasing losses. So when you lose your first $100, it feels pretty bad. In fact, that loss is more powerful than the amount of pleasure that you gain from gaining $100. Prospect theory says if you lose a second $100, the second $100 actually doesn't bother you as much. The additional pain of the second $100 is less than that initial pain you felt from the first $100.
And then if you lose a third $100 after that, the extra pain after that is even harder to perceive. And that's quite different from standard econ, because standard econ assumes as you lose more and more money, the harm actually increases because those dollars become more important to you as you have less total wealth. Prospect theory is a psychological theory that says we've become sort of desensitized to changes as we move away from the reference point.
MARK: Yeah, I found I encountered this. My first job out of college was working with traders in financial futures and options in Chicago. And you would find traders that if they were up, let's say by the midday, they would just kind of take the rest of the day off, you know, to kind of bank their gains. But if they were down, they would often be sent home on purpose because they would oftentimes start trading recklessly, desperately trying to get back to zero for the day—that break-even point.
DANIEL: Yeah.
MARK: Right?
DANIEL: Right.
MARK: So even if, you know, those particular people didn't have sort of the language of prospect theory, they sort of had that intuition that this was something that people did.
DANIEL: Exactly, that's a famous prediction of prospect theory that predicts that people take sort of dumb gambles when they're, you know, in the red or when they're in the domain of losses. And yeah, the point of prospect theory is to explain that type of behavior. And it explains it by saying when you're down a bit you want to take a gamble because you feel like if you lose a little bit more, it's no big deal because you're already down. But if you were to get back to that reference point, get back to break even, it would feel really good. Whereas in reality, if you lose a little bit more, that is a big deal. We underestimate the harm of the additional losses when we're in that loss area already.
MARK: So let's talk about how this applies to golf. And you weren't the first person to study this, but you kind of extended that work in a way we thought was super interesting. So maybe explain that a little bit about what the study was and what some of your findings were relative to the reference point that golfers seemed to pay attention to.
DANIEL: So just to comment just briefly on the value of sports data for behavioral econ work—one of the best features of sports data is that it's clean and it's accurate and there's a lot of it. And it comes from the real world. So if you wonder why economists are playing around with sports data, part of it, a big reason is just the availability of data on human behavior. It's like a lab outside the lab.
And golf is especially well suited for studying prospect theory because there's this built-in clear reference point on each individual hole of par, the par for that hole, right? So par is what very good golfers, professional golfers are…essentially what they're supposed to score on the hole. Of course, they want to beat par. They want to score less than par, and sometimes they do worse than par. They get a score that's above par. So, you know, one of the challenges of studying prospect theory outside of the lab is it's often unclear. What is the reference point? What's the expectation? But with golf, the reference point was super clear.
And the first paper that recognized this was not mine. It's a famous paper. It's discussed in Kahneman's, you know, magnum opus book, Thinking Fast and Slow. So in this paper, these behavioral economists studied what happens when golfers have the chance to beat par. In other words, they're taking a putt for what's called birdie—that's one stroke below par—versus when they're taking that same putt—a putt from the same distance, same elevation and stuff—but the putt is for par.
And so standard economics would say when you're putting in a professional tournament, every stroke for most of the tournament—especially the first couple, say the first round especially—every stroke is equally important. So whether you're putting for birdie or putting for par, you should putt in the same way. You should put the same effort into it and putt with the same strategy.
But prospect theory says that people think about the reference point, their score versus par. And so when they're putting for birdie, they might putt differently than to make par. And in particular, when people are putting for par, that means if you miss it, you're worse than your reference point. And that's a very painful thing. So you might try really hard to make that putt. Whereas when you're putting to beat par, it's nice to beat par, but it's not as important. So you might not put quite as much effort into it. And they did find that that's what happened, that people actually putt better, more accurately, when they're putting for par than when they're putting to beat par or for birdie, for a given putt difficulty level. So that was nice evidence of the importance of prospect theory and reference points outside the lab and high stakes setting, because these guys are playing for millions.
And what my co-author Jeremy Arks and I did was we realized that golfers might not just think about how they're doing versus par on a given hole in deciding how much effort to put into any given putt or whether to putt aggressively or more conservatively. They might think about how they've done versus par on recent holes or for the round or even for the tournament. And we realized this because we actually…we were not initially motivated to study prospect theory. We started off thinking about a different issue, the hot hand.
So we both have done some work on the hot hand before this. The hot hand, as you might know—maybe many of the listeners here know—the hot hand in basketball has been controversial for decades because psychologists and social scientists claim that it was essentially imagined that the basketball players don't actually get hot. And when we see them make a few shots in a row, we think they're hot. We're making a cognitive error.
So there's continued to be work in this area, and one question is, "How does the hot hand, or the perceived hot hand, vary across contexts?" And so we thought golf would be a nice context for looking to see, you know, do golfers get hot when they've played well over the last few holes? Does that predict better performance on the next hole? And we found that was not the case. In fact, it was the opposite.
So we found that if, you know, Joe golfer, if he got a birdie on the last hole, he was actually less likely to get a birdie on the next hole. He was likely to perform worse in that sense and the next. So that's the exact opposite of the hot hand, because the hot hand would predict, you birdie the last hole, you might be hot, you're more likely to birdie the next hole. We found, you birdie the last hole, you become less likely than normal to birdie the next. And we realized prospect theory is probably the explanation for that. Because if golfers think, "OK, I'm better than par recently. That means I can slack off a little. I can take it easy now. And I can be a little more conservative." And if they slack off a little and are a little more conservative, that's going to make them less likely to beat par, to do better than par on a subsequent hole. That's what we found. So we think prospect theory explained that.
MARK: And I think what's super interesting here is that we've got multiple kind of cognitive decision-making biases kind of interacting with one another. And then what you're trying to do is kind of tease them apart a little bit. Is that a fair description?
DANIEL: Yeah, I mean…so in reality, there are almost always going to be multiple psychological and other factors that are going to influence behavior and decisions. And so even though golf, it seems like a pretty simple game. The data is pretty clean and pretty easy to analyze. There are these two major forces, the hot hand and prospect theory, which actually push in exact opposite directions, which is useful for analysis because that means if you find no effect at all, it's a little ambiguous, right? Because it could be that the two effects cancel out. So we have these two forces, but it's also the interpretation of the result is really clean. Teasing it apart is very simple in a sense because there's only one way to explain people going from good to bad, and it has to be prospect theory.
Whereas in basketball, like in the NBA, if you see—we also observe that in real games—when players have made a shot or two or three recently, they tend to have a lower field goal percentage on subsequent shots. And it's hard to interpret that because that could be due to better defense or worse shot selection.
In golf, there's no defense. So when bad follows good, we don't have to worry about as many possible explanations as in other contexts. Pretty sure it's prospect theory where people are saying, "I'm in the domain of gains, so to speak, versus my reference point. I just beat my reference point, which gives me the chance to slack off a bit." And that's probably a bad decision, right? Because if you're a professional golfer, every stroke is equally important in that first round especially.
MARK: We're going to get on to basketball, in particular college basketball, here in a second. But before we do that, another thing you and Jeremy Akers, the other thing you did was look at different types of reference points and how they influence behavior, I believe. So tell us a little bit about that.
DANIEL: Yeah, so we thought, okay, so golfers might think about how they did in the last hole and feel like they're doing better than their reference point if they performed par in the last hole. But they also, you know, score versus par for the round is another natural thing for humans to think about. Whereas again, par, it's just a reference point. And standard econ would say a stroke is a stroke.
And then there's also score versus par for the tournament. And we did find that when, in the first round, when golfers are beating par for the round, they're below par for the round, they also become less likely to beat par to birdie the next hole. And it can't be hot hand again. Even if they didn't birdie the last hole. So suppose you're at hole 10 or something, and you got a par on hole nine. So you're not thinking, "I just birdied the last hole on par 10, so I'm going to slack off." But suppose you're three under par for the round heading into hole 10, and you parred the last hole, that actually predicts worse performance on hole 10—that you're less likely to birdie hole 10.
And then we also found that the other side of the hot hand, the cold hand, the idea that when you're doing poorly, you might be truly having a bad day and be likely to perform poorly in the next hole. And that cannot be explained by prospect theory, because prospect theory says when you're down, when you're in the losses area, you're supposed to try harder to get up into the gains area. So we basically concluded the cold hand in golf is more powerful than the hot hand. These professional golfers, if they get hot, it's not strong enough to outweigh a prospect theory effect.
But even though they're pros, they do seem to get rattled and have bad days or bad tournaments, despite the fact that given that you're down versus your reference point, you're supposed to be putting in extra effort and doing better than ever.
And you can see things get kind of complicated and confusing, but we ultimately concluded prospect theory effects are strong enough to dominate the hot hand but seem not strong enough to dominate the cold hand.
MARK: Why don't we move on to the basketball study? Although just one more word on golf. You've got a lot of time between shots, so you're…the golfer, unlike the basketball player who's making kind of quick decisions, the golfer has all this time between shots, which they need to focus on the game. But there's all these other sort of emotional factors that are going through their heads as well. So I think it makes for a very interesting sport in a lot of ways.
Dan Stone talked about his analysis of the PGA and golf. If you're a fan of the links, Schwab is a new original podcast all about golf called Invested in the Game. Host Mason Reed talks with golf entrepreneurs, golf pros and course architects, to name just a few. It debuted this month and we'll link to it as well in the show notes.
Let's talk a little bit about then, this paper is called March Madness Under Reaction to Hot and Cold Hands in NCAA Basketball. And there you were taking a look at this idea of, you know, momentum. Does a team have a positive momentum or negative momentum going into the tournament and whether people pay enough attention to that when they're filling out their bracket. So tell me a little bit more about that study.
DANIEL: Sure. So again, it was motivated by our interest in the hot hand and the cold hand. So we use the term momentum because we're looking at team performance rather than performance by an individual shooter or player. We thought it made a little more sense to, rather than saying a particular team has the hot hand, the team has momentum.
And again, part of the motivation was data availability, to be frank, because we realized that heading into the tournament, of course, each team is given a seed[2] and question: Do the seeds properly incorporate the recent performance of teams heading into the tournament? And we actually suspected, I suspected anyway, that hot teams are going to be overrated. We're going to be given seeds which were too high, too generous, right? So I suspected that the NCAA committee, which determines the seeds, would overreact to recent performance, sort of overrate the teams that seem hot. This one, you know, really caught us by surprise.
So first of all, after digging into a bit, we learned that the committee claims…they haven't always claimed this, but starting, I think it was in 2010, they issued a public statement that they were going to put equal weight on every game throughout the season in determining their seeding, OK? So in other words, they're basically saying that they're not coming up with the seeds in a way that's intended to measure how good or bad teams are heading into the tournament. It's supposed to be sort of a reflection of overall season performance.
MARK: Yeah, a win. I think they've said things like, "A win in November is just as important as a win in February."
DANIEL: Yeah. Right. So that…if teams actually do get hot or cold, that immediately suggests that the teams that are hot are going to be under seeded, because if you're given a number five seed—suppose you win your first 20 games and lose your last 10, to take an extreme case—you get a number five seed because the tournaments…the committee says, "Well, it doesn't matter that you lost your last 10. You're 20 and 10, that's pretty good." That team is…that's an easy upset…relatively easy upset to predict if the cold hand is real, if the 10 losses are not just a coincidence. And we found that is the case actually, that starting after 2010, yes, teams that are hot heading into the tournament do tend to do better than other teams with the same seed. Teams that are cold tend to do worse. And even before 2010, before they made that public statement, we found similar effects. And we also found that the vaguest of the point spreads do take into account how you're doing heading into the tournament, and they take it into account properly or appropriately. So in other words, teams that are either hot or cold heading into the tournament are no more likely to beat the spread, or not beat the point spread, than any other team. And that means the point spread incorporates that recent performance appropriately.
So this study turned out to be kind of a pro hot hand study because it found that the hot hand at the team level and the cold hand especially—again, the cold hand is stronger, I think—that it was real and that surprisingly, surprisingly to us anyway, it was not captured in these seeds. We thought, you know, even if they say, you know, they're going to treat all the games equally, it's human to put more weight in a recency bias and hot hand bias to put more weight on the recent games, but they don't do it. And this contributes to their being upsets, right? The less accurate the seeds are, the more upsets they're going to be if they don't pay attention to recent performance.
MARK: So maybe let's abstract away a little bit from these sports examples. What are some other examples where, you know, whether in finance or business decision making, where you see both of the effects you were just talking about, where you see them play out?
DANIEL: The real question with the hot and the cold hand are, there's no one right answer about whether the hot hand is real and what the magni…it all depends on the situation, right? And sometimes hot hand happens, sometimes it happens to a greater degree than others. But what is also true, and what I really am very confident in saying, is that we tend to see the hot hand much more often than we should. In other words, when we see the player make three shots in a row, we think they're hot. We think they're truly…they're better today when they probably just got lucky. And this is called the hot hand bias, inferring or believing something is hot based on too little evidence. And that kind of thing can come up in all kinds of situations, business and non-business situations.
I honestly see it in myself doing Wordle. So I'll go through these little streaks of scores that seem good to me, you know, three days in a row, and then I'll have another three days where my score is worse than what I normally hope to do. And I'm like, "Oh man, am I losing it or I've really figured out this wordle thing?" And of course it's just randomness. It's just flipping a coin and getting heads or tails three times in a row.
So the hot hand bias, it can affect all kinds of business settings. Anytime you have someone in a work situation who has a good performance, a streak of a good performance or bad performances, we have to be careful not to overreact to those streaks and to remember that even due to just total randomness and independent outcomes, we're going to see those streaks.
And then in terms of reference points, I think reference points affect consumer behavior and consumers certainly think very much in reference points, because if you expect Netflix to be $10 a month, standard economics would say if Netflix raises their price by a dollar, you don't get offended by it…don't get bent out of shape. You just say to yourself, "Is this the price that I'm willing to pay?" If so, you pay it. If not, you drop your Netflix subscription. But in reality, people flip out after certain price increases, right? That's because they have a reference point and when the price is higher than that reference point, it feels like a psychological loss and these losses are very painful.
And similarly, standard economics predicts that what workers are paid is quite flexible on the upside and the downside so that when firms are going through downtimes, firms would say, "Hey, employees, we have to pay you a little bit less now." We know in reality that doesn't happen much, right? And the downtimes firms are much more likely to lay off their employees than to cut their pay. And again, I think prospect theory helps explain it because people hate wage cuts, right? We think a wage cut is a loss compared to our reference point of the wage we were receiving before. And unhappy workers are bad news for firms because they're not going to be as productive. Who knows what sort of moral hazard they might engage in? They could slack off or they could do something worse. So firms, rather than get on the bad side of their workers and cut wages a little bit, they'd rather get rid of the workers altogether, and this can lead to all kinds of other issues. So that's where I see prospect theory really having big implications.
MARK: Last question for you, Dan, before I let you go. I wanted to ask you, what are you working on right now, you know, in your research? How are you focusing it right now?
DANIEL: Yeah, so I have mostly moved away from work using sports data. I have been working on political polarization actually for quite a while. My research and work in this area has been on how do behavioral mistakes, behavioral biases contribute to polarization, and this form of polarization called affective polarization, which is emotional polarization. Why do our behavioral biases make us more emotionally polarized toward those we disagree with politically or disagree with in general, more polarized than we should be, rationally speaking. And I'm still thinking about that stuff, working on that stuff. I have this project called Media Trades. We try to get together people with different viewpoints on political issues together to exchange media content, get people out of their echo chambers a little bit. So yeah, trying to save the world with that stuff. Got a ways to go, but I'm trying anyway.
MARK: Well, that's really important work. Glad you're focusing your analytical superpowers on that. Professor Daniel F. Stone is an associate professor of economics at Bowdoin College. Dan, thanks for being here.
DANIEL: Thank you again for having me. It was a lot of fun. Enjoyed it.
MARK: We'll have to wrap it up there. Daniel Stone is an associate professor of economics at Bowdoin College and chair of the economics department. I also wanted to mention that he's also used some of these techniques to look at political polarization and written a non-technical book on applying behavioral economics to this issue. The book is titled Undue Hate: A Behavioral Economic Analysis of Hostile Polarization in US Politics and Beyond. We'll include a link in the show notes.
As I mentioned at the outset, we keep score in many parts of our financial life, and that means it helps to have an understanding of prospect theory, loss aversion, and reference points.
The key point for me is to understand your reference point. This is the point against which you compare your performance. The easiest thing to do with your portfolio is to look at each and every part of it to see if you made money today or lost money today. That's useful, but what's more useful is to compare how your overall portfolio is doing. If you're diversified, it's unreasonable to expect everything to do well on every day. You also need to look at your goals and ask yourself, "Am I still on track to achieve my financial goals along the timeline I've established?"
Everyone wants to shoot the lights out when it comes to performance, but it's not
realistic to do that each and every time period. If you're still on track to reach your goals, then you have less to worry about. The point is to keep your eye on the prize. "What's my ultimate goal?" Figure that out and use that as your most important reference point.
In sports like NFL football, if a team has a winning record of 14 wins and 2 losses, they don't get too worried about the last game of the regular season. They're in the playoffs, they've probably earned home field advantage. Their main goal – their reference point – is to win the Super Bowl and they aren't going to anything in that last regular season game to jeopardize that.
Going back to financial matters, let's imagine you're keeping score and you're coming up short relative to your long-term goal. Here's where sports analogies breakdown. Lots of sports is black-and-white: winning or losing. Much of real life isn't like that.
Let's say you have your dream home in your sights, but it's just a little out of your price range. So you adjust. Maybe you look for a home in a neighborhood that's not quite as expensive, or you search for a two-bedroom instead of three. Maybe you decide you don't absolutely need a pool.
Life is lived along a continuum. It's not all or nothing. Sometimes you have to adjust your goals. If you can't buy your ideal home, you don't throw up your hands and quit. You tweak your goal. You adjust your reference point as needed. It's far better to be realistic.
And with that, it's a wrap on this episode. Thanks for listening. I'll be back in a couple of weeks with another show. In the meantime, if you'd like to hear more from me, you can follow me on my LinkedIn page or at X @MarkRiepe. That's M-A-R-K-R-I-E-P-E.
And if you like the show, please consider leaving us a rating or review on Apple Podcasts or comment on the show if you listen to it via Spotify. We always like new listeners. And if you know someone who might like the show, please tell them about it and how they can follow us for free in their favorite podcasting app.
For important disclosures, see the show notes and schwab.com/FinancialDecoder.
[1] Guthrie, Arlo, "City of New Orleans," lyrics, lyricadvisor.com, accessed May 7, 2025. https://www.streetdirectory.com/lyricadvisor/song/pelue/city_of_new_orleans/
[2] In basketball, a "seed" refers to a team's ranking or standing within a tournament or playoff system. It determines how a team is placed in the bracket and the matchups it will face.
