Prospect Theory Overview & Examples

What is Prospect Theory?

Prospect Theory states that individuals place greater weight on losses than gains while making decisions. It is a descriptive model of how individuals make decisions involving risk and uncertainty proposed by Daniel Kahneman and Amos Tversky in 1979. Prospect theory describes how people evaluate and choose between different options.

A critical component of Prospect theory is that our minds don’t evenly match the power of gains and losses. For instance, John Gottman’s research finds that a happy relationship requires approximately five positive encounters to counteract the impact of just one negative encounter, underscoring the disproportionate weight of losses in our perception of well-being. Additionally, friendships can take years to cultivate, but a single harmful event can swiftly endanger it.

In financial terms, a loss of $1,000 has a greater impact than gaining $1,000. Consequently, you’d have to gain more than $1,000 to offset the psychological loss of $1,000.

Prospect theory was developed by Kahneman and Tversky using empirical studies on how people make decisions to manage risk. They found that losses tend to produce larger negative emotional impacts than gains. This asymmetric weighting favors loss avoidance over potential gains and affects how individuals sort and rank the choices.

Prospect Theory Examples

Prospect theory explains why we often make choices that may seem irrational at first glance. In short, people are more likely to take risks to avoid losses.

Here are three real-life examples illustrating how it influences our decisions.

Investment Choices

Consider an investor faced with two investment options. Option A offers a guaranteed return of $1000, while Option B offers a 50% chance of winning $2000 and a 50% chance of winning nothing. These two choices offer the same expected or average outcome of a $1,000 gain. Despite the potential for a higher payoff with Option B, many investors take the guaranteed $1,000 instead of the chance for $2,000 due to loss aversion.

Prospect theory suggests that the fear of losing $2000 in Option B outweighs the potential gain, leading individuals to favor the guaranteed but lower amount.

Health Decisions

Imagine deciding whether to undergo a medical procedure with known risks and benefits. Prospect theory predicts that individuals may be more risk-averse regarding potential losses (such as experiencing adverse side effects) than gains (such as improved health outcomes). As a result, individuals may forego the procedure to avoid the possibility of adverse outcomes, even if the expected benefits outweigh the risks.

Choosing a Dish at a Restaurant

Picture yourself at your favorite restaurant, perusing the menu for dinner options. On the one hand, there’s your go-to dish—the one you’ve ordered countless times before, always satisfied with its familiar flavors and reliability. On the other hand, there’s a tempting new addition to the menu, boasting exotic ingredients and intriguing flavor combinations you’ve yet to experience.

In this scenario, the tendency to stick with the old favorite dish relates to loss aversion—the fear of disappointment or regret associated with trying something new. People often perceive the familiar dish as a safer option because they have previous positive experiences with it and know exactly what to expect regarding taste and satisfaction. The risk of not enjoying the new dish outweighs the possible gain of discovering a new favorite. Therefore, individuals may opt for the old favorite to minimize the perceived loss and maintain a sense of comfort and certainty in their dining experience.

In these examples, prospect theory provides valuable insights into how individuals weigh risks and rewards, prioritize specific outcomes over others, and ultimately make decisions that may deviate from traditional economic models. Understanding the underlying psychological mechanisms enables us to navigate decision-making processes more effectively in various aspects of life.

How the Prospect Theory Guides Decision-Making

Have you ever wondered how we humans make decisions? Prospect theory suggests there are two distinct stages.

Editing Phase

First, we have the “editing” phase, where our brains sift through the options. We order outcomes using handy rules of thumb, deciding what’s on par, setting a reference point, and labeling outcomes as either losses or gains.

The editing phase is crucial because it can introduce biases that linger throughout the decision-making process. Overlooking unlikely outcomes or misjudging their probabilities during this phase can lead to suboptimal decisions.

Evaluation Phase

After the editing, we move on to the evaluation phase. This phase involves calculating each option’s value or utility based on potential outcomes and their probabilities. It’s like weighing each possibility on a scale and choosing the one with the most benefits.

It’s crucial to understand that these decisions aren’t always grounded in rational calculations. According to prospect theory, individuals often lean towards risk aversion in high-stakes scenarios and risk acceptance when stakes are lower. In simpler terms, they’re more inclined to choose options that minimize losses rather than ones that maximize expected gains.

Let’s see how these biases work their way into prospect theory.

Cognitive Biases Involved in the Prospect Theory

Prospect theory encompasses several cognitive biases that influence decision-making under uncertainty. Learn more about the various types of Cognitive Biases.

Some of the key cognitive biases that feed into it include the following:

Loss aversion: This bias refers to the preference for avoiding losses over acquiring equivalent gains. Prospect theory says people are more sensitive to losses than gains of the same size, leading them to make decisions that prioritize minimizing losses.

Probability weighting: Prospect theory proposes that individuals tend to overweight lower probabilities and underweight larger probabilities when evaluating uncertain outcomes. People may give disproportionate weight to unlikely events, leading to decisions deviating from the expected outcomes.

Reference dependence: According to prospect theory, individuals evaluate outcomes relative to a reference point, such as their current situation or a predetermined expectation. This bias can lead to framing effects, where the way options are presented or framed can influence decision-making.

Diminishing sensitivity to gains and losses: Prospect theory suggests that individuals experience diminishing sensitivity to outcome changes as gains or losses increase. People can perceive smaller changes in outcomes as more significant when the stakes are low but less critical when the stakes are high.

These cognitive biases provide insights into how the prospect theory works in real-world situations.

Overcoming Prospect Theory Biases

Grasping prospect theory helps individuals mitigate biases and make more rational decisions. Consider an investor who acknowledges a tendency toward overly favoring high-probability events. They can counterbalance that by emphasizing low-probability outcomes more.

Additionally, reframing potential outcomes can diminish the influence of cognitive biases. Rather than focusing solely on gain or loss, shifting perspective to assess the expected outcome value can help alleviate loss-aversion bias.

Reference

Kahneman, D., & Tversky, A. (1979). Prospect theory: An analysis of decision under risk. Econometrica, 47, 263-291.