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Prospect Theory: What It Is and How It Works, With Examples

Definition

Prospect Theory is a psychological theory in behavioral economics that describes how individuals choose between probabilistic alternatives that involve risk, highlighting the potential for irrational decision behavior. It suggests people make decisions based on the perceived gains instead of the final outcome, proving that people are more affected by potential losses than potential gains. For instance, an individual is more likely to opt for a certain gain of $500, rather than taking a 50% chance to gain $1000, despite both options theoretically offering the same value.

Phonetic

“Prospect Theory: What It Is and How It Works, With Examples” would be phonetically transcribed as:”Pross-pekt Thee-uh-ree: Wuht It Iz And How It Wurks, With Eg-zam-puhls”

Key Takeaways

1. Definition of Prospect Theory

Prospect Theory, developed by Daniel Kahneman and Amos Tversky in 1979, is an influential behavioural economic theory that describes how individuals assess potential losses and gains when making decisions. The theory argues that people often make decisions based on the perceived gains rather than the final outcome, which is why people might behave differently when faced with a scenario of potential loss.

2. Key Components of Prospect Theory

One of the main aspects of Prospect Theory is the concept of reference points or “status quo”. Individuals tend to take the current situation as a reference point and consider changes as either gains or losses from this point. Another critical concept of Prospect Theory is that individuals place more weight on the potential loss than on an equivalent gain. This is known as ‘loss aversion’. Finally, ‘probability weighting’ is another crucial component where individuals overestimate the probability of unlikely events occurring and underestimate the probability of likely events.

3. Examples of Prospect Theory in Practice

One practical example of Prospect Theory is in the field of finance and investment. Investors often hold on to losing stocks for too long, due to their aversion to recognizing the loss. They tend to avoid selling a loss-making investment, hoping that it will bounce back – an example of loss aversion. Similarly, insurance companies capitalise on our tendency to overestimate the likelihood of unlikely events (e.g., disasters), hence we buy insurance – a real-life example of probability weighting.

Importance

Prospect Theory is a crucial concept in business and finance as it provides insightful understanding into how people make decisions about risks, especially in contexts involving potential gains and losses. Developed by psychologists Daniel Kahneman and Amos Tversky, it challenges traditional economic models implying humans are always rational and utility maximizers, and instead asserts that individuals often behave irrationally when faced with potential gains and losses. By accounting for cognitive biases, emotions, and subjective perceptions of gain and loss, Prospect Theory allows businesses to better predict consumer behavior and implement more effective strategies. For example, it can assist marketers in structuring pricing and discounts in a way that consumer’s perceive as a ‘gain’ to drive purchases, or guide investment strategies by understanding how investors react to potential profits and losses. Hence, the theory is critical in facilitating more accurate decision-making and strategy formulation in various business scenarios.

Explanation

Prospect theory is primarily used to understand and analyze how individuals pick between different options or prospects that involve risk wherein the probability of outcomes is uncertain. Developed by psychologists Daniel Kahneman and Amos Tversky, this theory is instrumental in the field of behavioral finance and economics. It serves as a substitute for expected utility theory, which was the predominant decision-making theory that suggested that people behave entirely rationally, which is often not the case. Instead, prospect theory provides a more accurate representation of human decision-making because it considers the potential losses and gains perceived by people when making a choice.The purpose of prospect theory is to demonstrate the concept of loss aversion, i.e., people’s tendencies to feel the pain of losing more intensively than the joy of gaining. For instance, the joy you receive from finding $50 is less than the pain you feel for losing $50. This theory is widely used in finance and business to optimize pricing strategies, formulate policies, and design investment choices that can cater to the investors’ irrationalities. For example, a company may offer a $100 rebate on a $1000 item, positioning it as a gain, rather than just advertising the item for $900 to accommodate the customer’s inclination towards perceived gains.

Examples

1. Insurance Purchases: Prospect theory is evident in how people approach insurance. Although it may not be highly probable for a catastrophic event to occur, such as a major health issue or a destructive house fire, people are usually willing to pay for costly insurance plans. This can be seen as a reflection of prospect theory because individuals are more bent towards mitigating potential losses (like the loss incurred from such fatal incidents) even though from a rational or statistical point of view, the probability of such incidents is relatively low.2. Investing in Stock Market: Go with a situation where an investor holds onto a declining stock, hoping it will go back up, despite evidence suggesting further decline. According to the prospect theory, the pain of selling a stock at a loss is much greater than the pleasure of selling the stock at an equal amount of gain. Therefore, investors will hold onto declining stocks longer than they should, just to avoid the pain of realizing a loss.3. Marketing and Pricing Strategies: This theory is frequently used in marketing to influence consumer behavior. For instance, a product is more likely to be purchased if it is marketed with a sales price (e.g., “was $100, now $75”) rather than simply stating the new price. Even though customers are paying the same amount in both scenarios ($75), they perceive the first option as preventing loss or gaining a ‘deal’ , making it psychologically more attractive.

Frequently Asked Questions(FAQ)

What does the term ‘Prospect Theory’ signify?

Prospect Theory is a behavioral economic theory that describes the way people choose between probabilistic alternatives involving risk and uncertainty. This theory asserts that people often make decisions based on perceived gains, rather than on rational evaluations of potential losses and gains.2.

Who developed Prospect Theory?

Prospect Theory was developed by psychologists Daniel Kahneman and Amos Tversky in 1979. Their work on this theory won them a Nobel Prize in Economics in 2002.3.

How does Prospect Theory work?

Prospect Theory works by illustrating how individuals value gains and losses. Typically, people feel more pain in losing a certain amount of money than the pleasure they experience in gaining the same amount. In risk management decisions, they tend to overestimate the probability of occurrence of low probability events and underestimate the probability of high probability events.4.

Can you provide an example of Prospect Theory in action?

Sure, let’s say an individual is presented with two scenarios. In the first scenario, they are guaranteed a gift of $500. In the second scenario, they have a 50% chance of receiving $1000 and a 50% chance of receiving nothing. According to Prospect Theory, most individuals will choose the first scenario (guaranteed $500) despite the expected value being exactly the same in both scenarios.5.

What is the significance of Prospect Theory in financial decision making?

Prospect Theory provides insights into irrational behaviors commonly found in financial markets. Understanding Prospect Theory can help financial professionals and investors craft better investment strategies, taking into account how investors’ perceptions of gains and losses affect their decisions.6.

How is Prospect Theory different from Utility Theory?

While traditional Utility Theory assumes individuals are rational and always make utility-maximizing decisions, Prospect Theory accounts for irrational decision making. Also, Utility Theory does not distinguish between potential losses and gains, while Prospect Theory asserts that losses and gains are valued differently. 7.

What is loss aversion in relation to Prospect Theory?

Loss aversion, a significant concept in Prospect Theory, means that people prefer to avoid losses to achieving equivalent gains. It shows the emotional impact of a loss is about twice as powerful as that of a gain.8.

Are there any criticisms of Prospect Theory?

Some critique elements of Prospect Theory like its descriptive rather than predictive nature, and its potential oversimplification of humans’ complex decision-making processes. Nevertheless, it provides a valuable perspective on the bias in people’s financial decision-making.

Related Finance Terms

  • Value Function: A key concept in prospect theory that expresses the idea that losses and gains are valued differently. The value function is typically graphed as an s-shaped curve, where losses are felt more intensely than equivalent gains.
  • Loss Aversion: A central idea of prospect theory, stating that people will generally risk more to avoid a loss than to achieve a gain. It is driven by the emotional impact of losses being greater than that of gains.
  • Probability Weighting: This occurs when people assign more weight to certain outcomes based on their perceived probabilities rather than the actual probabilities. In prospect theory, individuals overweight small probabilities and underweight large probabilities.
  • Reference Point: Another principle of prospect theory where decision making is influenced by the way choices are framed. Individuals assess the value of losses and gains relative to a specific reference point.
  • Framing Effect: A cognitive bias where people decide on options based on whether the options are presented with positive or negative semantics. i.e. as a loss or as a gain.

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