What Is Prospect Theory?
Prospect theory assumes that losses and gains are valued differently, and thus individuals make decisions based on perceived gains instead of perceived losses. Also known as loss aversion theory, the general concept is that if two choices are put before an individual, both equal, with one presented in terms of potential gains and the other in terms of potential losses, the former option will be chosen.
Key Takeaways
- Prospect theory says that investors value gains and losses differently, placing more weight on perceived gains vs. perceived gains with greater risk.
- An investor presented with two choices, both equal, will choose the one presented in terms of potential gains.
- Prospect theory is also known as loss aversion theory.
- Prospect theory is part of behavioral economics, suggesting investors choose perceived gains because losses cause a greater emotional impact.
- The certainty effect says individuals prefer certain outcomes over probable ones, while the isolation effect says individuals cancel out similar information when making a decision.
How Prospect Theory Works
Prospect theory belongs to the behavioral economic subgroup, describing how individuals make a choice between probabilistic alternatives where risk is involved and the probability of different outcomes is unknown. This theory was formulated in 1979 and further developed in 1992 by Amos Tversky and Daniel Kahneman, deeming it more psychologically accurate in how decisions are made compared with expected utility theory.
The underlying explanation for an individual’s behavior, under prospect theory, is that because the choices are independent and singular, the probability of a gain or a loss is reasonably assumed as being 50/50 instead of the probability that is actually presented. Essentially, the probability of a gain is generally perceived as greater.
Tversky and Kahneman proposed that losses cause a greater emotional impact on an individual than does an equivalent amount of gain, so given choices presented two ways—with both offering the same result—an individual will pick the option offering perceived gains.
For example, assume that the end result of receiving $25. One option is being given $25 outright. The other option is being given $50 and then having to give back $25. The utility of the $25 is exactly the same in both options. However, individuals are most likely to choose to receive straight cash because a single gain is generally observed as more favorable than initially having more cash and then suffering a loss.
Phases of Prospect Theory
Prospect theory asserts that decisions are made through a two-stage process. Instead of considering all available information and possible options (which would be impossible), humans use a two-step process to narrow down the most important information. These steps are described as the editing phase and the evaluation phase.
The Editing Phase
The editing phase is where people decide which information will be used in the evaluation stage. Decision makers will use mental shortcuts to assess which information is important and what options are available. They also decide which outcomes are most desirable and even rank their priorities.
The editing phase is important because it can introduce biases that emerge later in the decision process. If an individual does not consider certain unlikely outcomes or makes an incorrect assessment of that outcome's probability, they may end up making suboptimal decisions later on.
The Evaluation Phase
This is the stage where people make their final decisions, based on the assessments made in the editing phase. People weigh the probability of each outcome and take actions based on the perceived likelihood and desirability of each outcome.
It is important to note that these decisions are not necessarily based on rational calculations. Prospect theory posits that people tend to be risk-averse when the stakes are high, and risk-accepting when the stakes are low. In other words, they tend to make choices that minimize losses rather than maximize expected gains.
Characteristics of Prospect Theory
Prospect theory suggests that humans tend to prefer certainties over probabilities. For example, suppose that you have a choice between being given $50, and a 50% chance of winning $100. Most people will take the $50, even though the expected value of the two options is exactly the same.
Prospect theory also asserts that people underestimate (or even ignore) outcomes with a low probability. Consequently, they also tend to overestimate the probability of likely events, resulting in a bias that neglects improbable outcomes. This is particularly relevant to investors, who must consider the possibility of unforeseen black swan events.
Although there is no difference in the actual gains or losses of a certain product, prospect theory says investors will choose the product that offers the most perceived gains.
How to Overcome Biases
Understanding prospect theory can help individuals overcome their biases and make more rational choices. For example, an investor who is aware of their bias toward high-probability events can compensate by giving extra consideration to low-probability ones.
It also helps to reframe possible outcomes in a way that reduces the impact of cognitive biases. Instead of thinking in terms of gain or loss, you can instead think in terms of the value of expected outcomes, without using the present as a reference point. This can reduce one’s loss aversion bias.
Outcomes
According to Tversky and Kahneman, the certainty effect is exhibited when people prefer certain outcomes and underweigh outcomes that are only probable. The certainty effect leads to individuals avoiding risk when there is a prospect of a sure gain. It also contributes to individuals seeking risk when one of their options is a sure loss.
The isolation effect occurs when people have presented two options with the same outcome, but different routes to the outcome. In this case, people are likely to cancel out similar information to lighten the cognitive load, and their conclusions will vary depending on how the options are framed.
Example of Prospect Theory
Consider an investor who is given two pitches for the same mutual fund. The first advisor presents the fund to Sam, highlighting that it has an average return of 10% for the last three years. Meanwhile, a second advisor tells the investor that the fund has had above-average returns over the last decade, but has been in decline for the last three years.
Prospect theory says that although the investor has been pitched the exact same mutual fund, they are likely to buy from the first advisor. That is, the investor is more likely to buy the fund from the advisor who expresses the fund’s rate of return in terms of only gains, while the second advisor presented the fund as having high returns, but also losses.
What Does Prospect Theory Mean?
Prospect theory says that investors value gains and losses differently. That is, if an investor is presented an investment option based on potential gains, and another based on potential losses, the investor will choose an investment where potential gains are presented.
Why Is Prospect Theory Important?
It’s useful for investors to understand their biases, where losses tend to cause greater emotional impact than the equivalent gain. Prospect theory helps describe how decisions are made by investors.
What Are the Main Components of Prospect Theory?
Prospect theory is part of the behavioral economic subgroup. It describes how individuals make decisions between alternatives where risk is involved and the probability of different outcomes is unknown. There is a certainty effect exhibited in prospect theory, where people seek certain outcomes, underweighting only probable outcomes.
Who Proposed Prospect Theory?
Prospect theory was first introduced in 1979 by Amos Tversky and Daniel Kahneman, who later developed the idea in 1992. The pair said that prospect theory was better at accurately describing how decisions are made, compared with expected utility theory.
What Did Kahneman and Tversky Do?
Kahneman and Tversky proposed that losses have a greater emotional impact than a gain of the same amount. They said that given choices presented two ways—with both offering the same result—an individual will pick the option offering perceived gains.
The Bottom Line
Prospect theory says that individuals will accept an investment when the gains are presented, vs. the losses. That is, investors weigh potential gains more than potential gains with greater risk.