Prospect Theory

Prospect Theory, introduced by psychologists Daniel Kahneman and Amos Tversky in 1979, explores decision-making under risk and uncertainty. It is a psychology theory that suggests that individuals prioritize avoiding losses over seeking gains, exhibiting characteristics like certainty preference, discounting small probabilities, relative positioning, and loss aversion.

The theory involves two phases: editing (framing effects) and evaluation (comparing outcomes). However, critics argue it lacks psychological depth and fails to explain how decision-makers generate frames.

Despite criticisms, Prospect Theory remains influential in understanding decision-making processes across various disciplines, including financial decision-making in international relations.

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.

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 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. Two psychologists, Daniel Kahneman and Amos Tversky, introduced the theory 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,” which was published in the “Econometrica” journal in 1979. Since the Prospect Theory was developed, it’s been used in various disciplines. It is used to evaluate various aspects of political decision-making in international relations.

How Does Prospect Theory Work?

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 Prospect Theory

Prospect 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 more potential 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% chance of losing. Most people will choose option A since it provides a guaranteed 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 their wealth. By discounting the small probabilities, people end up choosing higher-risk options with higher probabilities.

3. Relative positioning

Relative positioning means that people tend to focus less on their final income or wealth, and more on the relative gains or losses that they will get. If their relative position does not improve with increases in income, they will not feel better off. This 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, no individual will feel better off. However, if the person gets a 10% raise, and other people fail to get a raise, that person will feel better off and richer than everyone 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 in losses, the person will focus on the loss even though they emerged with a $100 net gain. This shows that people are more concerned about losses rather than gains.

Examples of Prospect Theory

Prospect Theory has numerous applications in finance and banking, shaping how individuals make investment decisions and manage their finances.

Investment Choices

Investors often exhibit risk aversion when choosing between investment options. For instance, they may prefer investments with guaranteed returns or lower volatility, even if they offer lower potential gains. This aligns with Prospect Theory’s emphasis on avoiding losses and seeking certainty.

Stock Market Behavior

Prospect Theory helps explain phenomena like the disposition effect, where investors tend to hold onto losing investments too long and sell winning investments too soon. This behavior stems from the aversion to realizing losses, as individuals are more distressed by losses than they are pleased by gains of an equivalent amount.

Behavior during Market Volatility

During periods of market volatility or economic uncertainty, investors may become more risk-averse and prioritize protecting their existing wealth over seeking new investment opportunities. Prospect Theory predicts that individuals will become even more loss-averse in such situations, potentially leading to conservative investment decisions or even withdrawal from the market altogether.

Loan Repayment Behavior

Borrowers’ decisions regarding loan repayment can also be influenced by Prospect Theory. They may prioritize paying off high-interest loans or debts with smaller balances first, as it offers a sense of progress and reduces the perceived loss associated with interest payments.

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 note 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 issues.

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 CFI resources will be helpful:

• Investing: A Beginner’s Guide
• Moral Hazard
• Risk-Adjusted Return Ratios
• Total Probability Rule
• See all wealth management resources