Understanding Prospect Theory: Its Definition and Operation, Demonstrated with Illustrative Examples
Life's Swings: Navigating Gains and Losses
Prospect Theory and Its Impact
Prospect theory provides a fresh perspective on decision-making, suggesting that our fear of losses weighs more on our choices compared to the excitement for potential gains. This explains a concept known as loss aversion[1][2][3].
Emotions and Uneven Weights
When faced with two equal choices, one focusing on potential gains and the other on possible losses, most individuals tend to lean towards the one emphasizing gains. Surprising, isn't it? But proposal theory explains that the choice isn't just about the benefits or rewards but also the potential risk of losses and our fear of them[4].
Beyond Common Assumptions
Prospect theory challenges the presumption that we weigh risks and rewards evenly when making decisions. Instead, the apprehension of risk carries more weight than the anticipation of a reward[3][4].
Key Takeaways
- Prospect theory scrutinizes our decision-making habits.
- It argues that we value gains and losses unequally, prioritizing risk avoidance over the pursuit of rewards.
- In investing, we might opt for a stable gain over a potential loss[4][5].
- Prospect theory is a vital component of behavioral economics[1][2].
Into the Heart of Prospect Theory
Prospect theory falls under the branch of psychology known as Behavioral Economics. It investigates our choices between alternatives when possibilities are diverse, and risk is imminent[1][6].
The theory was first thought up by economists Amos Tversky and Daniel Kahneman in 1979. They proposed it as a more credible alternative to an earlier theory, the Expected Utility Theory[7].
The Logic of Choices
Prospect theory assumes that people consider the likelihood of gain or loss in any choice to be the same. However, the fear of loss carries more significant emotional weight[1][4][6].
A loss is perceived to have more forceful emotional repercussions than an equivalent amount of gain. Choices presented distinctly, either emphasizing potential gains or losses, can influence our decisions[1][4].
Choices: Turning the Tide
For example, imagine an individual is presented with $25, which can be had right away or a higher sum of $50, with the condition that they would have to return $25 at the end. In either scenario, the individual receives $25, yet people often choose the immediate payout. The perceived gain feels more appealing than an increase in reward followed by a loss.
A Tale of Two Phases
Prospect theory suggests that individuals use a two-step process to arrive at a decision. This process includes an editing phase and an evaluation phase.
The Editing Phase
In the editing phase, an individual narrows down the most vital information and decides which data will be considered for the decision-making task[5].
Bias may emerge during this stage if the person overlooks unfavorable outcomes or underestimates their likelihood[5].
The Evaluation Phase
During the evaluation phase, the decision-maker assesses the possible outcomes and makes a choice based on each outcome's perceived probability and desirability[5].
It's important to note that rationality may not always play a significant role in this stage of decision-making. People can be risk-averse when the risks are high and more willing to take risks when the stakes are low[8].
Characteristics of Prospect Theory
Prospect theory states that humans tend to prefer certainty over probability. We underestimate or even ignore low-probability outcomes and overemphasize high-probability events, a phenomenon that becomes crucial for investors in anticipating black swan events.
Overcoming Biases
Comprehending prospect theory can help us overcome our cognitive biases, supporting us in making more rational decisions. For example, an investor can give more attention to improbable outcomes by considering their possibilities and effects more thoughtfully[5].
Additionally, reframing possible outcomes in a way that doesn't focus on gains or losses can help reduce our loss aversion and make our decision-making process more efficient[1][4].
Certainty and Probability
Tversky and Kahneman posited that given multiple offers, people will pick the certain outcome, avoiding risk when there's a chance for a guaranteed gain and taking risks when there's the prospect of a sure loss[9].
Prospect Theory in Action
Consider an investor who is choosing between two mutual fund presentations from separate advisers. The first adviser stresses the fund's consistent 10% growth rate over the last three years. The second adviser, however, points out that the fund's growth rate has been declining on a yearly basis compared to the previous decade.
According to prospect theory, the investor is likely to choose the fund based on the first adviser's description, favoring the gains over a more nuanced consideration of the declining growth rate.
What Does Prospect Theory Mean?
Prospect theory asserts that our preference for gains and losses varies significantly. We prioritize minimizing potential losses over maximizing potential gains.
How Relevant is Prospect Theory to Us?
Prospect theory helps us understand the potential biases that can influence our investment decisions, with a primary focus on our aversion to losses. Recognizing and addressing these biases can lead to more informed, balanced decision-making[8].
The Main Elements of Prospect Theory
Prospect theory sheds light on our decision-making process when risk is involved and the possible outcomes are uncertain. It reveals a phenomenon known as the certainty effect, in which people prefer certain outcomes and are careful to avoid risks with the potential for losses. It encourages individuals to seek risks when there is a possibility of a guaranteed loss[9].
[1] https://www.sciencedirect.com/topics/psychology/prospect-theory[2] https://en.wikipedia.org/wiki/Prospect_theory[3] https://behavioraleconomics.berkeley.edu/concepts/prospect-theory/[4] https://www.investopedia.com/terms/p/prospecttheory.asp[5] https://www.investopedia.com/terms/k/kahneman-tversky.asp[6] https://psychology.jrank.org/pages/10144/Prospect-Theory.html[7] https://www.ncbi.nlm.nih.gov/pmc/articles/PMC3057438/[8] https://www.investopedia.com/articles/personal-finance/022215/how-prospect-theory-affects-behavior-investors.asp[9] https://www.investopedia.com/iex101/theories/psychological_theories/prospect_theory.asp
- Prospect theory's influence extends to various financial arenas, as it highlights our aversion to losses in trading, investments, and even initial coin offerings (ICOs).
- Decision-making in DeFi (decentralized finance) environments could be impacted by our preference for stable gains over potential losses, a trait rooted in prospect theory.
- While exploring different finance opportunities, it's crucial to consider the role of prospect theory, as it may influence our decisions based on risk tolerance and loss aversion.
