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Prospect Theory

A psychology theory that states that people make decisions based on perceived losses or gains

What is Prospect Theory?

Prospect theory is a psychology theory that describes how people make decisions when presented with alternatives that involve risk, probability, and uncertainty. It holds that people make decisions based on perceived losses or gains.

 

Prospect Theory

 

Given the choice of equal probabilities, most people would choose to retain the wealth that they already have, rather than risk the chance to increase their current wealth. People are usually averse to the possibility of losing, such that they would rather take a risk to avoid a loss rather than take a risk to make an equivalent gain.

 

History of Prospect Theory

The prospect theory is sometimes referred to as the loss-aversion theory. The theory was introduced by two psychologists, Daniel Kahneman, and Amos Tversky, to describe how humans make decisions when presented with several choices.

The theory was contained in the paper “Prospect Theory: An Analysis of Decision under Risk” that was published in the “Econometrica” journal in 1979. Since it was developed, the prospect theory’s been used in various disciplines, and it is used to evaluate various aspects of political decision-making in international relations.

 

Phases of Prospect Theory

The theory describes the decision-making process in two phases, which include:

 

1. Editing phase

The editing phase refers to how people involved in decision-making characterize the options for choice or the framing effects. The effects explain how a person’s choice is influenced by the wording, order, or method in which the choices are presented.

An example to demonstrate the framing effect can be the choices that cancer patients are given. Usually, cancer patients are presented with the choice of undergoing surgery or chemotherapy to treat their illnesses, and they make a decision based on whether the outcome statistics are presented in terms of survival rates or mortality rates. Once the choices have been framed ready for decision-making, the theory enters the second phase.

 

2. Evaluation phase

In the evaluation phase, people tend to behave as if they would make a decision based on the potential outcomes and choose the option with a higher utility. The phase uses statistical analysis to measure and compare the outcomes of each prospect. The evaluation phase comprises two indices, i.e., the value function and the weighting function, which are used to compare the prospects.

 

Features of the Prospect Theory

The prospects theory comes with the following characteristics:

 

1. Certainty

When presented with several options to choose from, humans show a strong preference for the option with certainty. They are willing to sacrifice the option that offers income in order to achieve more certainty. For example, assume that a lottery provides two options, A and B.

Option A provides a guaranteed win of $100 while option B provides the possibility of winning $200, with a 70% chance of winning and a 30% of losing. A lottery player will choose option A since it provides a guarantee to win, even though it offers a lower return compared to B.

 

2. Small probabilities

People tend to discount very small probabilities even if there is a possibility of losing all the wealth. By discounting the small probabilities, people end up choosing the high-risk options with higher probabilities.

 

3. Relative positioning

Relative positioning means that people tend to focus less on their final income or wealth, but more on the relative gains or losses that they will get. If their relative position does not improve with increases in the income, they will not feel better off. It means that people tend to compare themselves to their neighbors, friends and family members, and are less interested in whether they are better off than they were some years back.

For example, if everybody in the office gets a 20% raise, that person will not feel better off. However, if the person gets a 10% raise, and other people fail to get a raise, that person will be better off and richer than anybody else.

 

4. Loss aversion

People tend to give more weight to losses rather than gains made by taking a certain option. For example, if a person makes $200 in profits and $100 is losses, the person will focus on the loss even though they emerged with a $100 in gains. This shows that people are more concerned about the losses rather than the gains.

 

Criticism of Prospect Theory

One of the criticisms of the prospects theory is that it lacks psychological explanations for the process it talks about. The criticism comes from other psychologists who notes that factors such as human emotional and affective responses that are important in the decision-making process are absent in the model.

The theory is also criticized for the inadequate framing theory that explains why actors generate the frames they use. Decision-makers often need to deal with competing frames across various foreign policy issues, and it often causes an overlap.

 

Additional Resources

CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful:

  • Investing: A Beginner’s Guide
  • Moral Hazard
  • Risk-Adjusted Return Ratios
  • Total Probability Rule

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