Understanding the Impact of Prospect Theory on Decision Making
Prospect theory suggests that losses and gains are valued differently, leading individuals to make decisions based on perceived gains rather than perceived losses. Often referred to as the loss-aversion theory, it posits that if two choices are presented equally—one framed in terms of potential gains and the other in terms of possible losses—individuals will choose the former.
Key Takeaways
- Prospect theory emphasizes that investors value gains and losses differently, often prioritizing perceived gains over perceived losses.
- When given two equal choices, an investor typically selects the one framed in terms of potential gains.
- Also known as the loss-aversion theory, prospect theory is a cornerstone of behavioral economics.
- It further implies that losses impact individuals more emotionally compared to equivalent gains.
- Concepts like the certainty effect and isolation effect elaborate on differing preferences in decision scenarios.
The Mechanics of Prospect Theory
Prospect theory falls under the umbrella of behavioral economics. It describes how individuals decide between probabilistic alternatives where risks are involved, and the probability of outcomes is unknown. This theory, initially proposed in 1979 and refined in 1992 by Amos Tversky and Daniel Kahneman, challenges the traditional expected utility theory by offering a psychologically accurate depiction of decision-making processes.
The essence of prospect theory lies in the independent and singular evaluation of choices, often resulting in a misperceived 50/50 probability of gain or loss regardless of actual probabilities. Typically, the perception of a potential gain outweighs the perception of a potential loss.
Phases of Prospect Theory
Prospect theory outlines a two-stage decision-making process: the editing phase and the evaluation phase.
The Editing Phase
Here, individuals assess and determine which information warrants consideration. Mental shortcuts help sift through options and identify desirable outcomes. Prioritization happens during this phase, potentially introducing biases that can influence the final decision.
For example, dismissing unlikely outcomes or misjudging their probabilities may lead to poor decisions later.
The Evaluation Phase
This stage involves the final decision-making process. People evaluate the probabilities and desirability of each outcome, taking actions based on these assessments. Decisions are often influenced by a risk-averse stance for high stakes and a risk-accepting one for low stakes, underscoring the principle of loss aversion.
Key Characteristics of Prospect Theory
Prospect theory reveals the human tendency to favor certainties over probabilities. Given a choice between a guaranteed $50 and a 50% chance of $100, most people would choose the guaranteed amount, even though the expected value is the same.
Additionally, the theory highlights how individuals often underestimate or ignore low-probability outcomes while overestimating high-probability ones—creating a bias especially relevant to investors subjected to unexpected black swan events.
Overcoming Biases
Awareness of prospect theory can lead to more rational decision-making. For instance, investors cognizant of their bias towards high-probability events can ensure they also evaluate low-probability outcomes adequately.
- Reframing outcomes without using the present as a reference point helps minimize cognitive biases. By focusing on the expected value of outcomes rather than immediate gains or losses, individuals can mitigate loss-aversion bias.
Real-World Application and Outcomes
The certainty effect shows a preference for guaranteed outcomes and a tendency to undervalue probable outcomes. This behavior drives risk aversion when potential gains are certain and risk acceptance to avoid certain losses.
Meanwhile, the isolation effect occurs when identical outcomes—presented via different paths—lead individuals to disregard identical information, lightening cognitive load and ultimately influencing decisions based on framing perspectives.
Example of Prospect Theory
Picture an advisor pitching two identical mutual funds to a client. The first advisor emphasizes consistent average returns of 10% over three years, while the second mentions declining performance despite above-average returns over a decade. The client is likely to prefer the first advisor’s fund due to the emphasis on gains.
Conclusion
Prospect theory fundamentally asserts that presented gains override losses in decision-making, highlighting how investors weigh potential gains more significantly than potential losses. Understanding and applying this theory can help individuals and investors make more informed, rational decisions.
Related Terms: Loss-Aversion, Certainty Effect, Isolation Effect, Black Swan Events, Behavioral Economics.
References
- Tversky, Amos & Kahneman, Daniel. “Prospect Theory: an Analysis of Decision Under Risk”, Econometrica, vol. 47, no. 2, March 1979, pp. 263-292.
- Tversky, Amos & Kahneman, Daniel. “Advances in Prospect Theory: Cumulative Representation of Uncertainty”, Journal of Risk and Uncertainty, vol. 5, pp. 297-323, 1992.
- ScienceDirect. “Prospect Theory”.
- Simply Psychology. “Prospect Theory in Psychology: Loss Aversion Bias”.
- Simply Psychology. “Prospect Theory in Psychology: Loss Aversion Bias”.
- Melbourne School of Psychological Sciences. “Human Decision Making in Black Swan Situations”. Page 1.
- Tversky, Amos & Kahneman, Daniel. “Prospect Theory: an Analysis of Decision Under Risk”, Econometrica, vol. 47, no. 2, March 1979, pp. 265, 271, 274.
