Scribd
Upload
100 views4 pages

Prospect Theory

Prospect theory proposes that people make decisions based on potential losses and gains relative to a reference point rather than final outcomes. It finds that losses loom larger than gains, causing risk aversion for gains but risk seeking for losses. The theory was developed by Kahneman and Tversky based on empirical evidence that contradicted expected utility theory. It introduced concepts like loss aversion, framing effects, and nonlinear weighting of probabilities that better explain human decision making.

Uploaded by

Tamanna Rath
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as TXT, PDF, TXT or read online on Scribd
100 views4 pages

Prospect Theory

Prospect theory proposes that people make decisions based on potential losses and gains relative to a reference point rather than final outcomes. It finds that losses loom larger than gains, causing risk aversion for gains but risk seeking for losses. The theory was developed by Kahneman and Tversky based on empirical evidence that contradicted expected utility theory. It introduced concepts like loss aversion, framing effects, and nonlinear weighting of probabilities that better explain human decision making.

Uploaded by

Tamanna Rath
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as TXT, PDF, TXT or read online on Scribd
You are on page 1/ 4

Prospect Theory and Loss Aversion: How Users Make Decisions

When choosing among several alternatives, people avoid losses and optimize for sure
wins because the pain of losing is greater than the satisfaction of an equivalent
gain.
Loss aversion is an important psychological concept which receives increasing
atten-tion in economic analysis. It has first been proposed by Kahneman and
Tversky(1979) in the framework
of prospect theory, and later it has also been defined for choice under certainty
by Tversky and Kahneman (1991). This theory was formulated in 1979 and further
developed in 1992 by
Amos Tversky and Daniel Kahneman, deeming it more psychologically accurate of how
decisions are made when compared to the expected utility theory.

Well-known examples are the endowment effect(Thaler, 1980), the equity premium
puzzle (Benartzi and Thaler, 1995),
and the status quo bias (Samuelson and Zeckhauser, 1988). In recent years loss
aversion has also frequently been applied in behavioral finance.

Kahneman and Tversky’s (1979, p. 279) view of loss aversion is as follows: An


individual is loss averse if she or he dislikes symmetric 50-50 bets and,
moreover,the aversiveness to such
bets increases with the absolute size of the stakes. This clearly is a behavioral
concept defined entirely in terms of preferences.

The key premise of prospect theory, Tversky and Kahneman's most important
theoretical contribution, is that choices are evaluated relative to a reference
point, e.g., the status quo.
The second assumption is that people are risk-averse about gains (relative to the
reference point) but risk-seeking about losses. The third premise is loss-aversion:
losing x hurts more
than gaining x helps.

THE FRAMEWORK

SYSTEM 1 VS. SYSTEM 2 THINKING

System 1 refers to automatic decision making (fast reaction) and 2 refers to


reflective thinking (requiring cognition).

Below is a question I like to ask during interviews (that comes from


Tversky/Kahneman’s research):

A bat and ball cost $1.10 in total. The bat costs $1 more than the ball. How much
does the ball cost?

If you are like many people your system 1 response is $0.10

If you have a strong system 2 checks in place you will do some quick math and
realize that isn’t possible. You will eventually get the right answer. Though very
few people have a
system 1 that would spit out the right answer.

This insight from Tversky/Kahneman is critical to understanding the results of


their work. Here is a great quote on what to do with this work:
The best we can do is compromise: learn to recongise situations in which mistakes
are likely and try harder to avoid significant mistakes when the stake are high. —
Daniel Kahneman,
Thinking Fast and Slow (page 28)

This is great advice for product and business leaders. We often have an initial
reaction (system 1) to a situation. Many times these are small decisions, but for
larger decisions we
should be aware of how the mind works.

HEURISTICS

While not technically part of Prospect Theory, this research led Tversky and
Kahneman to go deeper into the psychological reasoning of unreasonable decisions.

Representativeness: Captures the probability that an individual belongs to a


specific group.

Availability: This is the bias that human tendency thinks of examples that come
readily to mind are more representative than is actually the case.

Anchoring: is a cognitive bias where an individual relies too heavily on an initial


piece of information offered

The framing effect: People react to a particular choice in different ways depending
on how it was presented.

We tend to avoid risk when a positive frame is presented but seek risks when a
negative frame is presented.

this theory is primarily characterized by a value function and a nonlinear


transformation of the probability scale in that a value function is steeper for
losses than for gains,
and concave for gains, but convex for losses, while a nonlinear transformation of
the probability scale overweights small probabilities, but underweights high an
moderate probabilities.

VALUE/LOSS FUNCTION

The value function for a problem in the economics of the optimal accumulation of
information is calculated as a fixed point of a contraction mapping by direct
numerical iteration.

According to prospect theory, the value function v(·) exhibits the psychophysics of
diminishing sensitivity. That is, the marginal impact of a change in value
diminishes with the
distance from a relevant reference point. For monetary outcomes, the status quo
generally serves as the reference point distinguishing losses from gains, so that
the function is
concave for gains and convex for losses (see Figure 11.2a). Concavity for gains
contributes to risk aversion for gains, as with the standard utility function
(Figure 11.1). Convexity
for losses, on the other hand, contributes to risk seeking for losses.

This tendency to be risk averse for moderate-probability gains and risk seeking for
moderate-probability losses may contribute to the “disposition effect,” in which
investors have
a greater tendency to sell stocks in their portfolios that have risen rather than
fallen since purchase

It is important to note that loss aversion, which gives rise to risk aversion for
mixed (gain–loss) prospects (e.g., most people reject a 50–50 chance to gain $100
or lose $100) should
be distinguished from convexity of the value function for losses, which gives rise
to risk-seeking for pure loss prospects (e.g., most people prefer a 50–50 chance to
lose $100 or
nothing, to losing $50 for sure).

WEIGHTING FUNCTION

Just as PT suggests a subjective transformation of objective outcomes, it also


suggests a psychological transformation of objective probabilities, p, into
subjective
decision weights, π(p), which indicates the impact the event has on the decision.
The original PT decision weight function, shown in Figure 10.4b, formalized
empirical observations
showing that small probability events receive more weight than they should, based
on their likelihood of occurrence, while large probabilities receive too little
weight.
More recently, a more complex continuous function has been substituted (Tversky
and Kahneman, 1992).

The table below shows the probability of an event occurring and the decision
weight that someone places against it. People put a lot of value on certainty, as
can be seen in the table.

(eco folder mein photo)

RISK AVERSION
(video)

CONCLUSION

Tversky and Kahneman were pioneers in ushering in behavioral economics.


Prospect theory has provided an inspiring perspective from which choice under risk
and uncertainty may
be understood. As an enormous number of studies have undertaken with great interest
to address issues pertinent
to this influential theory, there still exist unexplored issues or unanswered
puzzles related to the evidence-based
theory, which was proposed with an attempt to pave the way for better understanding
and representing human
psychological operations in choice under risk and uncertainty

You might also like

pFad - Phonifier reborn

Pfad - The Proxy pFad of © 2024 Garber Painting. All rights reserved.

Note: This service is not intended for secure transactions such as banking, social media, email, or purchasing. Use at your own risk. We assume no liability whatsoever for broken pages.


Alternative Proxies:

Alternative Proxy

pFad Proxy

pFad v3 Proxy

pFad v4 Proxy