Prospect theory
Prospect theory is a psychological framework that seeks to explain how individuals make decisions involving risk, particularly in financial contexts. Developed by psychologists Daniel Kahneman and Amos Tversky, the theory posits that people tend to be risk-averse, often opting for choices that minimize the potential for loss rather than maximizing potential gains. This behavior stems from the observation that the pain of losing is felt more intensely than the pleasure of an equivalent gain.
One of the key concepts within prospect theory is the "value function," which illustrates that individuals assign greater weight to certain outcomes, often preferring a guaranteed smaller reward over a risky large one, even when the odds favor the latter. The theory also introduces the idea of "loss aversion," highlighting that the emotional impact of losses is significantly stronger than that of gains, influencing decision-making processes. Additionally, factors such as the isolation effect—where individuals focus on the differences between options rather than their similarities—play a crucial role in how choices are evaluated under uncertainty.
Prospect theory has practical applications in various fields, including marketing and finance, where understanding human behavior can enhance strategies for consumer engagement and investment analysis. Overall, the theory provides valuable insights into the complexities of human decision-making in uncertain environments, reflecting a nuanced understanding of how we perceive risk and reward.
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Prospect theory
The prospect theory is a psychological explanation of why people make some of the choices they do, especially decisions related to money. The theory states that people are generally risk averse and that their decisions are weighted toward the options that lessen the chance of a loss and increase the chance of a win. The psychologists responsible for the theory believed this was because the discomfort of a loss is greater than the pleasure of a win. Businesspeople and researchers can use this theory to design sales campaigns and study questions that will take into account these behaviors and improve the likelihood of generating desired responses.
Background
The prospect theory originated with psychologists Daniel Kahneman and Amos Tversky. They first published their theory in 1979 in the academic economic journal Econometrica, and it went on to become one of the most cited articles ever published in the journal. The researchers observed that people faced with two alternatives will often choose the option with the smaller possibility of loss, even if the other option is, in fact, less likely to occur. This is the reason people buy renters' insurance or travel insurance. Even though in many communities it is unlikely that there will be a fire or theft at any particular residence, and even though more trips happen without incident than are canceled, many people would rather lose a small amount (the premium for the insurance) than potentially lose a larger amount in property or travel expenses.
Kahneman and Tversky were inspired to begin the studies that resulted in the prospect theory because they were interested in some apparently conflicting behaviors they observed. They noticed that if people were offered something with certainty and the possibility of something better, they would often choose the lesser option that was a sure thing. This is the principle behind the long-running game show Let's Make a Deal. People are told they have won a prize of moderate value; they can keep that prize or give it back and take a chance on what is behind door number one, door number two, or door number three. As the game goes on, the potential for bigger prizes increases, but there is always the risk that the next "prize" will be of little value. At some point, people operating under the prospect theory will opt to keep the lesser prize rather than risk what they have.
At the same time, Kahneman and Tversky noticed that if they offered the same people the choice of losing a set amount or the chance of losing nothing or twice as much, people often opted to take the risk in the hope of not losing anything. If someone was told they had to pay $1,000, but there was an option: they could flip a coin for the chance to not have to pay anything, or to pay $2,000, many people choose to flip the coin. Kahneman and Tversky found that these principles held even if the sure thing and the potential gain were equal. For instance, people were told that they won $900, but they could give it back for a chance at winning $1,000; the odds were 90 percent in favor of them winning the $1,000, but there was a 10 percent chance they would win nothing. The majority of people chose to take the $900, even though the other option they were weighing provided nearly equal results.
Prospect theory stands in opposition to the expected utility theory, which holds that people are good at assessing relative risks and probabilities and that losses and gains are seen in equal terms; in other words, it feels as good to gain $100 as it hurts to lose $100. The prospect theory disagrees with these assumptions. According to the prospect theory, people are not good judges of the probabilities of something happening, tending to overestimate the likelihood of something bad happening and underestimate the possibility of something good happening. For example, people are more likely to think that it will rain on their wedding day than they are to assume it will be nice weather. People are also likely to be more upset about losing a sum of money than they are to be excited about finding the same amount.
Overview
The prospect theory takes into account several factors that people weigh in making decisions that involve risk and reward. These include the degree of certainty of each option, the isolation effect that is involved, and loss aversion. Each plays a role in how people make loss or gain decisions, even if they are not consciously aware of them.
The theory holds that people tend to give more weight to a sure thing, or an option that has a great deal of certainty associated with it. Many people will choose this option rather than risk winning more if there is a chance they could walk away empty-handed. However, if the loss is the sure thing, people are more willing to take a chance at avoiding that loss, even if there is the potential for an even greater loss.
Another key factor in the prospect theory is the isolation effect. This refers to the tendency of a person making a decision to ignore the similarities and focus on the differences. This is believed to be in part because of cognitive load, or the brain's capacity for thinking about different things at the same time. When faced with a number of different elements to consider when weighing two options, there is likely to be more than the brain can actively think about at one time. As a result, similarities between the options are discounted and only the differences are considered in isolation from the other elements.
Finally, people are generally loss adverse and prefer to win. This is why winning $50 at a casino and then losing $40 feels like a bad day, even though the person is still $10 ahead. The pain of the loss is greater than the excitement over the win.
This theory plays a key role not only in understanding how individuals make decisions but also in understanding the behavior of groups of people. Advertisers can use the prospect theory to their advantage by showing people how the advertised product will help them avoid losing something they value. Marketers understand that offering people a coupon for 20 percent off is more likely to entice people to complete a survey than a chance to win $500. The theory also helps those analyzing financial markets to understand how and why people make investment decisions.
Bibliography
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