Prospect Theory

Imagine a scenario where you bet $10 on a baseball game and lose to a friend. The loss of $10 is not just a monetary loss, but also a psychological one. The disappointment of losing, the regret of the decision, and the comparison of what could have been if the bet was won, all contribute to the overall negative experience.

Suppose your friend offers you a chance to win your money back. You can either take a sure win of $5, or a 50% chance to win the full $10 back. According to prospect theory, most people would choose the sure win, even though the expected value of both options is the same. This is due to the certainty effect, where people prefer certain outcomes over uncertain ones.

Suppose your friend frames the options differently. Instead of saying that you’ll recoup $5, guaranteed, he presents the option as a $5 net loss. Even though the outcomes are the same, the framing of the options can significantly influence your decision. This is the framing effect, another key element of prospect theory.

Developed by Daniel Kahneman and Amos Tversky, prospect theory is a behavioral economic theory that describes how people make decisions under uncertainty. It focuses on four elements that affect economic decision making: certainty, framing, loss aversion, and relativity.

Certainty refers to our preference for guaranteed outcomes over uncertain ones. When offered a sure $10 or a 25% chance at $50, most people would choose the former. This is because the majority of us prefer a sure gain over a gamble with a higher expected value.

The second element, framing, relates to the way options and information are presented. The same option may appear more appealing when framed in one way compared to another. For example, people are more likely to choose a surgery if it is described as having a 90% survival rate rather than a 10% mortality rate, even though the two descriptions represent the same outcome.

The third element of prospect theory, loss aversion, refers to our tendency to prefer avoiding losses to acquiring equivalent gains. This is because losses are felt more intensely than gains of the same value. When we lose $20, the disappointment we feel is greater than the joy we might experience from finding $20 randomly.

Loss aversion has significant implications in behavioral finance. It explains why some investors tend to be overly conservative, focusing more on minimizing losses than on maximizing gains. Even when they can afford to take on more risk, the fear of potential losses can deter them from making profitable investments.

In the stock market, loss aversion can lead to premature selling of stocks. Investors may sell their stocks to realize a small gain, even when holding onto the stocks could lead to much larger profits. This behavior is driven by the desire to avoid the potential loss that comes with uncertainty. A bird in the hand is worth two in the bush, so to speak.

Loss aversion can also lead to other cognitive biases. For example, a gambler suffering from a losing streak may continue to place bets in an attempt to recoup his losses. This tendency, known as the sunk cost fallacy, contradicts the concept of sunk cost in conventional economics, which suggests that past investments should not affect future decisions as they can no longer be recovered.

The sunk cost fallacy refers to our tendency to continue a course of action even when it would be better to abandon it. This can lead to irrational decisions, as we may stick to a losing strategy simply because we are emotionally attached to the investments we have already made.

Loss aversion also partly explains the endowment effect, a cognitive bias where people place a higher value on items if they own it compared to if they do not. This is because the potential loss of giving up an item is perceived as greater than the potential gain of acquiring it.

Imagine two individuals. Bob has tens of thousands in debt. Joe has none but lives paycheck to paycheck. Who is more likely to be devastated by a $100 loss? According to prospect theory, it’s Joe. Losing $100 is just enough to land Joe in the red but won’t make much of an impact on Bob’s finances.

Similarly, consider Cynthia, who earns $50,000 a year, and Michelle, who earns four times as much. Who is more likely to appreciate a $5,000 raise? Again, according to prospect theory, it should be Cynthia, as a $5,000 raise represents a larger percentage increase for her. Michelle already earns enough. Past a certain point, additional income does not significantly increase happiness, a concept known as diminishing marginal utility.

These two examples illustrate the fourth element of prospect theory – reference points. According to the theory, we do not judge potential gains and losses in absolute terms. Instead, we view gains and losses relative to reference points, which can be arbitrary. The value of $100 differs from context to context depending on our reference point.

Despite the dominance of expected utility theory in conventional economics, prospect theory has gained widespread respect. It provides a more realistic picture of how people make decisions under uncertainty, taking into account psychological factors that traditional economic models often ignore.

Prospect theory offers a simple, straightforward framework for understanding economic decision making. It highlights the importance of certainty, framing, loss aversion, and reference points in shaping our choices. This makes it a valuable tool for economists, policymakers, and anyone interested in understanding human behavior.

Moreover, prospect theory can guide how options are presented to others. By understanding how people evaluate potential gains and losses, we can frame options in a way that influences decisions. This can be particularly useful in fields like marketing, negotiation, and policy design.

Recent research has built on prospect theory to further our understanding of decision making. One such study suggests that the behaviors illustrated in prospect theory are more prevalent in decisions and scenarios that we rarely encounter. As we gain experience and new information, we assess past choices and refine our thought process, effectively making our decision making more ‘rational.’

The more we encounter the same scenario, the more our decisions align with the predictions of expected utility theory. This suggests that familiarity can reduce the influence of cognitive biases as we learn from past experience.

One limitation of prospect theory is that it does not specify how reference points are determined. A 2006 paper by Botond Kőszegi and Matthew Rabin suggests that reference points are determined by our expectations of the economic outcomes of our choices. However, theorists have not reached a consensus, uncovering an extra layer of complexity to our understanding of decision making under uncertainty.

Since its introduction, prospect theory has been applied in domains beyond economics. In geriatric care, studies have found that relatives of residents diagnosed with cancer frame medical decisions within the larger context of the resident's life. They conclude that jeopardizing the chance for a peaceful dying process is too high a risk, demonstrating the influence of framing and loss aversion.

Political scientist Kurt Weyland has also used prospect theory to understand political decision making. According to him, political leaders at the height of their power do not take on risky initiatives. This observation aligns with the principles of loss aversion.

Weyland further suggests that in Latin America, politically weakened governments were more likely to take political risks in the form of potentially unpopular reforms despite the very real chance of political backlash. Again, this counterintuitive behavior lines up with prospect theory, particularly with the idea of assessing options from varying reference points.