Prospect theory

rospect Theory
REVIEWED BY JAMES CHEN

Updated Apr 11, 2018

What is the 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 possible losses, the former option will be
chosen.

BREAKING DOWN Prospect Theory

For example, consider an investor is given a pitch for the same mutual fund by
two separate financial advisors. One advisor presents the fund to the investor,
highlighting that it has an average return of 12% over the past three years. The
other advisor tells the investor that the fund has had above-average returns in
the past 10 years, but in recent years it has been declining. Prospect theory
assumes that though the investor was presented with the exact same mutual
fund, he is likely to buy the fund from the first advisor, who expressed the
fund’s rate of returnas an overall gain instead of the advisor presenting the fund
as having high returns and losses.

Behind Prospect Theory

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 of how decisions are made
when compared to the 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.

Perceived Gains Over Perceived Losses

Tversky and Kahneman proposed that losses cause 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 is receiving $25. One option is being
given the straight $25. The other option is gaining $50 and losing $25. The utility
of the $25 is exactly the same in both options. However, individuals are most
likely to choose receiving the straight cash because a single gain is generally
observed as more favorable than initially having more cash and then suffering a
loss.

Certainty and Isolation Effects in Prospect Theory

According to Tversky and Kahneman, the certainty effect is exhibited when
people prefer certain outcomes and underweight 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 are
presented two options with the same outcome, but different routes to the
outcome. In this case, people are likely to cancel out the similar information to
lighten the cognitive load, and their conclusions will vary depending on how the
options are framed.

The theory states:

“People make decisions based on the potential value of losses and gains rather than the
final outcome.”

Image Source:
According to Kahneman and Tversky, losses and gains are valued differently, and thus
users make decisions based on perceived gains instead of perceived losses.

For example, most people prefer winning $50 with certainty rather than taking a risky bet
in which they can toss a coin and either win $100 or nothing.

However, Kahneman and Tversky also found:

The same people when confronted with 100% chance of losing $50 versus a 50% chance
of no loss or $100 loss – they often choose the second option.

Now, prospect theory explains three biases people use when making decisions:

 Certainty: “This is when people tend to overweight options that are certain and
risk averse for gains.”
 Isolation effect: “Refers to people’s tendency to act on information that stands out
and differs from the rest.”
 Loss aversion: “When people prefer to avoid losses to acquire equivalent gains”

This post dives deep into these biases and shares few ideas and examples for introducing
them into your own marketing or business activities.

Ready? Let’s jump right in…

1. Certainty
According to Li & Chapman:

“The certainty effect happens when people overweight outcomes that are considered
certain over outcomes that are merely possible.”

In other words:

We would rather get an assured, lesser win than taking the chance at winning more [but
also risk possibly getting nothing]

Consider this example:

Which of the following option would you choose?

 100% chance to win $900.

 90% chance to win $1000 or nothing ($0)
Image Source:

With option 1, you’re assured to get $900.

While with option 2, there’s a 10% chance you could get $1000 or nothing.

Studies confirmed that nearly 80 percent of people will choose option 1.

The reason?

Most people avoid the risk and take the $900.

Now, consider this example:

Which of the following option would you choose?

 100% chance of losing $900

 90% chance of losing $1000 or nothing ($0)

Image Source:

With option 1, you’re assured to lose $900…

And with option 2 you have a 10% chance of losing either $1000 or nothing – $0.

Most people would prefer the second option.

Why?

Because when aiming to avoid losses, we become risk seeking and take the gamble over a
sure loss, in the hope of losing nothing.

Common sense might suggest that individuals combine the net effect of the gains
and the losses associated with any choice in order to make an educated
evaluation of whether that choice is desirable. An academic way of viewing this is
through the concept of “utility,” often used to describe enjoyment or desirability; it
seems logical that we should prefer those decisions which we believe will
maximize utility.

On the contrary, though, research has shown that individuals don’t necessarily
process information in such a rational way. In 1979, behavioral finance founders
Kahneman and Tversky presented a concept called prospect theory. Prospect
theory holds that people tend to value gains and losses differently from one
another, and, as a result, will base decisions on perceived gains rather than on
perceived losses. For that reason, a person faced with two equal choices that are
presented differently (one in terms of possible gains and one in terms of possible
losses) is likely to choose the one suggesting gains, even if the two choices yield
the same end result.

Prospect theory suggests that losses hit us harder. There is a greater emotional
impact associated with a loss than with an equivalent gain. As an example,
consider how you may react to the following two scenarios: 1) you find $50 lying
on the ground, and 2) you lose $50 and then subsequently find $100 lying on the
ground. If your reaction to the former scenario is more positive than to the latter,
you are experiencing the bias associated with prospect theory.

Evidence for Irrational Behavior

Kahneman and Tversky engaged in a series of studies in their work toward

developing prospect theory. Subjects were asked questions involving making
judgments between two monetary decisions that involved potential gains and
losses. Here is an example of two questions used in the study:

1. You have $1,000 and you must pick one of the following choices:

Choice A: You have a 50% chance of gaining $1,000, and a $50

chance of gaining $0.

Choice B: You have a 100% chance of gaining $500.

2. You have $2,000 and you must pick one of the following choices:

Choice A: You have a 50% chance of losing $1,000, and a 50%

chance of losing $0.

Choice B: You have a 100% chance of losing $500.

If these questions were to be answered logically, a subject might pick either “A”
or “B” in both situations. People who are inclined to choose “B” would be more
risk adverse than those who would choose “A”. However, the results of the study
showed that a significant majority of people chose “B” for question 1 and “A” for
question 2.

The implication of this result is that individuals are willing to settle for a
reasonable level of gains (even if they also have a reasonable chance of earning
more than those gains), but they are more likely to engage in risk-seeking
behaviors in situations in which they can limit their losses. Put differently, losses
tend to be weighted more heavily than an equivalent amount of gains.

This line of thinking resulted in the asymmetric value function:

This chart represents the difference in utility (i.e. the amount of pain or joy) that is
achieved as a result of a certain amount of gain or loss. This value function is not
necessarily accurate for every single person; rather, it represents a general
trend. One critical takeaway from this function is that a loss tends to create a
greater feeling of pain as compared to the joy created by an equivalent gain. In
the case of the chart, the absolute joy felt in finding $50 is significantly less than
the absolute pain caused by losing $50.

As a result of this tendency, during a series of multiple gain/loss events, each

event is valued individually and then combined in order to create a cumulative
feeling. Thus, if you were to find $50 and then lose $50, you’d probably end up
feeling more frustrated than you would if you hadn’t found or lost anything. This is
because the amount of joy gained from finding the money is outweighed by the
amount of pain experienced by losing it, so the net effect is a “loss” of utility.

Financial Relevance

Many illogical financial behaviors can be explained by prospect theory. For

example, consider people who refuse to work overtime because they don’t want
to pay more taxes. These people would benefit financially from the additional
after-tax income, but prospect theory suggests that the benefit they would
achieve from earning extra money for additional work does not outweigh the
sense of loss they feel when they pay additional taxes.
The disposition effect is the tendency that investors have to hold on to losing
stocks for too long and to sell winning stocks too soon. Prospect theory is useful
in explaining this phenomenon as well. The logical course of action would be to
do the opposite: to hold on to winning stocks in order to further gains, while
selling losing stocks in order to prevent additional losses.

The example of investors who sell winning stocks prematurely can be explained
by Kahneman and Tversky’s study, in which individuals settled for a lower
guaranteed gain of $500 as compared with a riskier option that could either yield
a gain of $1,000 or $0. Both subjects in the study and investors who hold winning
stocks in the real world are overeager to cash in on the gains that have already
been guaranteed. They are unwilling to take a risk to earn larger gains. This is an
example of typical risk-averse behavior. (To read more, check out A Look At Exit
Strategies and The Importance Of A Profit/Loss Plan.)

On the other hand, though, investors also tend to hold on to losing stocks for too
long. Investors tend to be willing to assume a higher level of risk on the chance
that they could avoid the negative utility of a potential loss (just like the
participants in the study). In reality, though, many losing stocks never recover,
and those investors end up incurring greater and greater losses as a result. (To
learn more, read The Art Of Selling A Losing Position.)

Avoiding the Disposition Effect

It is possible to reduce the disposition effect, thanks to a concept called hedonic

framing. As an example, for situations in which you have a chance of thinking of
something as one large gain or as a number of smaller gains (i.e. finding a $100
bill versus finding a $50 bill and then later finding another $50 bill), it’s best to
think of the latter option. This will help to maximize the positive utility you
experience.

On the other hand, for situations where you could either think of a situation as
one large loss or as a number of smaller losses (i.e. losing $100 or losing $50
two times), it’s better to think of the situation as one large loss. This creates less
negative utility, because there is a difference in the amount of pain associated
with combining the losses and with the amount associated with taking multiple
smaller losses.

In a situation you could interpret as either one large gain with a smaller loss or a
single smaller gain (i.e. $100 and -$50, or +$50), it’s likely that you’ll achieve
more positive utility from the single smaller gain.
Lastly, in situations that could be thought of as a large loss with a smaller gain or
as a smaller loss (i.e., -$100 and +55, versus -$45), it may be best to frame the
situation as separate losses and gains.

Try these methods of framing your thoughts,

One of the biggest challenges to our own success can be our own instinctive
behavioral biases. In previously discussing behavioral finance, we focused
on four common personality types of investors.

Now let's focus on the common behavioral biases that affect our investment
decisions. (For related reading, see: 6 Questions to Ask a Financial Advisor.)

The concept of behavioral finance helps us recognize our natural biases that
lead us to making illogical and often irrational decisions when it comes to
investments and finances. A prime example of this is the concept of prospect
theory, which is the idea that as humans, our emotional response to perceived
losses is different than to that of perceived gains. According to prospect
theory, losses for an investor feel twice as painful as gains feel good. Some
investors worry more about the marginal percentage change in their wealth
than they do about the amount of their wealth. This thought process is
backwards and can cause investors to fixate on the wrong issues. (For more
from Brad Sherman, see: Which Investor Personality Best Describes You?)

The chart below is a great example of this emotional rollercoaster and how it
impacts our investment decisions.
The Psychology of Investing Biases
Behavioral biases hit us all as investors and can vary depending upon our
investor personality type. These biases can be cognitive, illustrated by a
tendency to think and act in a certain way or follow a rule of thumb. Biases
can also be emotional: a tendency to take action based on feeling rather than
fact.

Pulled from a study by H. Kent Baker and Victor Ricciardi that looks at how
biases impact investor behavior, here are eight biases that can affect
investment decisions:

 Anchoring or Confirmation Bias: First impressions can be hard to

shake because we tend to selectively filter, paying more attention to
information that supports our opinions while ignoring the rest. Likewise,
we often resort to preconceived opinions when encountering something
— or someone — new. An investor whose thinking is subject to
confirmation bias would be more likely to look for information that
supports his or her original idea about an investment rather than seek
out information that contradicts it.
 Regret Aversion Bias: Also known as loss aversion, regret aversion
describes wanting to avoid the feeling of regret experienced after
 making a choice with a negative outcome. Investors who are influenced
by anticipated regret take less risk because it lessens the potential for
poor outcomes. Regret aversion can explain an investor's reluctance to
sell losing investments to avoid confronting the fact that they have made
poor decisions. (For more, see: Understanding Investor Behavior.)
 Disposition Effect Bias: This refers to a tendency to label investments
as winners or losers. Disposition effect bias can lead an investor to
hang onto an investment that no longer has any upside or sell a winning
investment too early to make up for previous losses. This is harmful
because it can increase capital gains taxes and can reduce returns
even before taxes.
 Hindsight Bias: Another common perception bias is hindsight bias,
which leads an investor to believe after the fact that the onset of a past
event was predictable and completely obvious whereas, in fact, the
event could not have been reasonably predicted.
 Familiarity Bias: This occurs when investors have a preference for
familiar or well-known investments despite the seemingly obvious gains
from diversification. The investor may feel anxiety when diversifying
investments between well known domestic securities and lesser known
international securities, as well as between both familiar and unfamiliar
stocks and bonds that are outside of his or her comfort zone. This can
lead to suboptimal portfolios with a greater a risk of losses.
 Self-attribution Bias: Investors who suffer from self-attribution bias
tend to attribute successful outcomes to their own actions and bad
outcomes to external factors. They often exhibit this bias as a means of
self-protection or self-enhancement. Investors affected by self-
attribution bias may become overconfident. (For more, see: The
Importance of Diversification.)
 Trend-chasing Bias: Investors often chase past performance in the
mistaken belief that historical returns predict future investment
performance. This tendency is complicated by the fact that some
product issuers may increase advertising when past performance is
high to attract new investors. Research demonstrates, however, that
investors do not benefit because performance usually fails to persist in
the future.
 Worry: The act of worrying is a natural — and common — human
emotion. Worry evokes memories and creates visions of possible future
scenarios that alter an investor’s judgment about personal finances.
 Anxiety about an investment increases its perceived risk and lowers the
level of risk tolerance. To avoid this bias, investors should match their
level of risk tolerancewith an appropriate asset allocation strategy.

Avoiding Behavioral Mistakes

By understanding the common behavioral mistakes investors make, a quality
financial planner will aim to help clients take the emotion out of investing by
creating a tactical, strategic investment plan customized to the individual.
Some examples of strategies that help with this include:

 Systematic Asset Allocation: We utilize investment strategies such

as dollar cost averaging to create a systematic plan of attack that takes
advantage of market fluctuations, even in a down market period.
 Risk Mitigation: The starting point of any investment plan starts with
understanding an individual's risk tolerance.