Thinking, Fast and Slow - Prospect Theory and Loss Aversion

By The Boy Who Procrastinates - March 09, 2019


In my earlier post, I have shared a book review on Thinking, Fast and Slow by Daniel Kahneman, chiefly on the subject of Anchoring Effect and its application on the financial decisions we make on a daily basis

Picking up where I left off, I will be focusing on one of the fundamental concepts of behaviorial economics introduced in the book. 



Prospect Theory

The prospect theory was developed by psychologists, Daniel Kahneman and the late Amos Tversky, as a theory of decision-making under conditions of risk and uncertainty. 

It runs contrary to the normative implications inherent in the classical theory of expected utility by mathematician Daniel Bernoulli (even though he has used the St. Petersburg paradox to demonstrate the limitation of expected value as standard decision rule). Instead, the prospect theory presents a more psychologically accurate model of human decision-making. 

It posits that (1) people make choices by framing around a reference point and that (2) people tend to overweight losses with respect to comparable gains and respond to the probabilities of such outcomes in a nonlinear fashion. 



Certainty

Problem 1: Which option will you choose?

  • Get $900 for sure
  • 90% chance to get $1,000 and 10% chance to get $0
Despite both options having the same expected utility, most people are likely to be risk averse and choose to receive the $900 for sure. This is because we tend to overweigh options that are certain and hence, adopt a risk adverse attitude towards gains. 

For example, awarding $120 cashback after charging $400 to a credit card might be a more appealing and effective marketing tactic than having a chance to win $150 after spending the equivalent amount.

But how will our choice differ if we construct the problem in the negative domain? 

Problem 2: Which option will you choose?

  • Lose $900 for sure
  • 90% chance to lose $1,000 and 10% chance to lose $0
If you are like most other people, you will probably choose to gamble in this scenario. The certain loss of $900 is very aversive and this drives people to be risk-seeking in the realm of losses. 

Fundamentally, the contrasting attitudes towards risk with favourable and unfavourable prospects depends largely on the way we frame outcomes as gains or losses.



Reference Point

Problem 3: In addition to whatever you own, you have been given $1,000 and are now asked to choose one of the following options: 

  • 50% chance to win $1,000
  • Get $500 for sure
Problem 4: In addition to whatever you own, you have been given $2,000 and are now asked to choose one of the following options: 

  • 50% chance to lose $1,000
  • Lose $500 for sure
You might have guessed it. Majority of the respondents preferred to receive $500 for sure in Problem 3 and accept the gamble to lose $1,000 in Problem 4. 

Even though the final states of wealth are identical in both scenarios, the comparison between them underscores the dominant role of a reference point from which the options are evaluated. 

The reference point of Problem 1 is higher than the current wealth by $1,000, and it is considered a gain of $500 if you were to increase your wealth by $1,500. Conversely, the reference point for Problem 2 is higher than the current wealth by $2,000 and increasing your wealth by $1,500 is considered a loss of $500. 

Therefore, an individual views monetary consequences in terms of changes from a neutral reference point. For financial outcomes, the common reference point is the status quo. For most investors, the entry prices at which they have taken position for their investment may be a reference point.

In other situations, it can be the outcome that you have expected or feel entitled to, for example the increment or bonus that your colleagues receive. Outcomes that are better than the reference point are considered gains and consequently outcomes below the reference point are losses. 



Loss Aversion

One basic tenet of the prospect theory is loss aversion. It reflects a prevalent avoidance behaviour involving choices that could lead to losses. To most people, losses loom larger than gains when weighted against each other, resulting in an asymmetrical impact in our decision-making process.

Many of the choices that we frequently come across are presented as an ambivalent shade of grey instead of a strictly dichromatic palette of black and white. There is a risk of loss and an opportunity for gain. Such scenarios with the element of mixed prospect can range from an investor evaluating the feasibility of investing in a company to the strategy employed in a soccer match.

To illustrate this, let's consider an elementary example of such quandary:

Problem 5: You are offered a gamble on the toss of a coin. Would you accept it?

  • Tail: Lose $100
  • Head: Win $150
Even though the expected value of the gamble is positive (an individual stands to gain more than he can lose), most people are likely to reject the game. This is because the fear of losing $100 is more intense than the hope of winning $150. 

For most of us, the amount we could possibly win has to be at least twice as large as the amount we could lose before we are willing to accept the gamble. 

Interestingly, our sensitivities to losses can be traced back to evolutionary history in which organisms that initiated urgent action in response to threats as compared to opportunities, have a better chance of survival and procreation. As such, it would make sense that we experience greater pain of loss than joy of gain of comparable magnitude. 


I don't like losses, sport. Nothing ruins my day more than losses.                — Gordon Gekko, Wall Street

Closing Thought

The prospect theory is one of the most influential concepts in behavioral economics which sheds light on the way we react to gains and losses. In most cases, people might be daunted and discouraged by the fear of making losses. This ultimately drive them to procrastinate or even abandon the idea of taking the first step to investing, even though they might be giving up on opportunities to earn more. 

Understanding the psychology of gains and losses may be a primary move to overcome our fear when it comes to investing.


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Disclaimer: Kindly note that this is not a sponsored post. The author is in no way affiliated with the publisher/author and does not receive any form of remuneration for this post. The Boy who Procrastinates has compiled the information for his own reference, with the hope that it will benefit others as well.

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3 comments

  1. Understanding the psychology of gains and losses may be a primary move to overcome our fear when it comes to investing - Thanks for sharing such wonderful advice. Much appreciated!!

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  2. Thanks for sharing the info. Really nice and informative.

    ReplyDelete