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Rospect Theory: Reviewed by James Chen
Rospect Theory: Reviewed by James Chen
Rospect Theory: Reviewed by James Chen
rospect Theory
REVIEWED BY JAMES CHEN
For example, assume that the end result is receiving $25. One option is being
given the straight $25. The other option is gaining $50 and losing $25. The utility
of the $25 is exactly the same in both options. However, individuals are most
likely to choose receiving the straight cash because a single gain is generally
observed as more favorable than initially having more cash and then suffering a
loss.
“People make decisions based on the potential value of losses and gains rather than the
final outcome.”
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According to Kahneman and Tversky, losses and gains are valued differently, and thus
users make decisions based on perceived gains instead of perceived losses.
For example, most people prefer winning $50 with certainty rather than taking a risky bet
in which they can toss a coin and either win $100 or nothing.
The same people when confronted with 100% chance of losing $50 versus a 50% chance
of no loss or $100 loss – they often choose the second option.
Now, prospect theory explains three biases people use when making decisions:
Certainty: “This is when people tend to overweight options that are certain and
risk averse for gains.”
Isolation effect: “Refers to people’s tendency to act on information that stands out
and differs from the rest.”
Loss aversion: “When people prefer to avoid losses to acquire equivalent gains”
This post dives deep into these biases and shares few ideas and examples for introducing
them into your own marketing or business activities.
1. Certainty
According to Li & Chapman:
“The certainty effect happens when people overweight outcomes that are considered
certain over outcomes that are merely possible.”
In other words:
We would rather get an assured, lesser win than taking the chance at winning more [but
also risk possibly getting nothing]
While with option 2, there’s a 10% chance you could get $1000 or nothing.
The reason?
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Why?
Because when aiming to avoid losses, we become risk seeking and take the gamble over a
sure loss, in the hope of losing nothing.
Common sense might suggest that individuals combine the net effect of the gains
and the losses associated with any choice in order to make an educated
evaluation of whether that choice is desirable. An academic way of viewing this is
through the concept of “utility,” often used to describe enjoyment or desirability; it
seems logical that we should prefer those decisions which we believe will
maximize utility.
On the contrary, though, research has shown that individuals don’t necessarily
process information in such a rational way. In 1979, behavioral finance founders
Kahneman and Tversky presented a concept called prospect theory. Prospect
theory holds that people tend to value gains and losses differently from one
another, and, as a result, will base decisions on perceived gains rather than on
perceived losses. For that reason, a person faced with two equal choices that are
presented differently (one in terms of possible gains and one in terms of possible
losses) is likely to choose the one suggesting gains, even if the two choices yield
the same end result.
Prospect theory suggests that losses hit us harder. There is a greater emotional
impact associated with a loss than with an equivalent gain. As an example,
consider how you may react to the following two scenarios: 1) you find $50 lying
on the ground, and 2) you lose $50 and then subsequently find $100 lying on the
ground. If your reaction to the former scenario is more positive than to the latter,
you are experiencing the bias associated with prospect theory.
1. You have $1,000 and you must pick one of the following choices:
2. You have $2,000 and you must pick one of the following choices:
If these questions were to be answered logically, a subject might pick either “A”
or “B” in both situations. People who are inclined to choose “B” would be more
risk adverse than those who would choose “A”. However, the results of the study
showed that a significant majority of people chose “B” for question 1 and “A” for
question 2.
The implication of this result is that individuals are willing to settle for a
reasonable level of gains (even if they also have a reasonable chance of earning
more than those gains), but they are more likely to engage in risk-seeking
behaviors in situations in which they can limit their losses. Put differently, losses
tend to be weighted more heavily than an equivalent amount of gains.
Financial Relevance
The example of investors who sell winning stocks prematurely can be explained
by Kahneman and Tversky’s study, in which individuals settled for a lower
guaranteed gain of $500 as compared with a riskier option that could either yield
a gain of $1,000 or $0. Both subjects in the study and investors who hold winning
stocks in the real world are overeager to cash in on the gains that have already
been guaranteed. They are unwilling to take a risk to earn larger gains. This is an
example of typical risk-averse behavior. (To read more, check out A Look At Exit
Strategies and The Importance Of A Profit/Loss Plan.)
On the other hand, though, investors also tend to hold on to losing stocks for too
long. Investors tend to be willing to assume a higher level of risk on the chance
that they could avoid the negative utility of a potential loss (just like the
participants in the study). In reality, though, many losing stocks never recover,
and those investors end up incurring greater and greater losses as a result. (To
learn more, read The Art Of Selling A Losing Position.)
On the other hand, for situations where you could either think of a situation as
one large loss or as a number of smaller losses (i.e. losing $100 or losing $50
two times), it’s better to think of the situation as one large loss. This creates less
negative utility, because there is a difference in the amount of pain associated
with combining the losses and with the amount associated with taking multiple
smaller losses.
In a situation you could interpret as either one large gain with a smaller loss or a
single smaller gain (i.e. $100 and -$50, or +$50), it’s likely that you’ll achieve
more positive utility from the single smaller gain.
Lastly, in situations that could be thought of as a large loss with a smaller gain or
as a smaller loss (i.e., -$100 and +55, versus -$45), it may be best to frame the
situation as separate losses and gains.
One of the biggest challenges to our own success can be our own instinctive
behavioral biases. In previously discussing behavioral finance, we focused
on four common personality types of investors.
Now let's focus on the common behavioral biases that affect our investment
decisions. (For related reading, see: 6 Questions to Ask a Financial Advisor.)
The concept of behavioral finance helps us recognize our natural biases that
lead us to making illogical and often irrational decisions when it comes to
investments and finances. A prime example of this is the concept of prospect
theory, which is the idea that as humans, our emotional response to perceived
losses is different than to that of perceived gains. According to prospect
theory, losses for an investor feel twice as painful as gains feel good. Some
investors worry more about the marginal percentage change in their wealth
than they do about the amount of their wealth. This thought process is
backwards and can cause investors to fixate on the wrong issues. (For more
from Brad Sherman, see: Which Investor Personality Best Describes You?)
The chart below is a great example of this emotional rollercoaster and how it
impacts our investment decisions.
The Psychology of Investing Biases
Behavioral biases hit us all as investors and can vary depending upon our
investor personality type. These biases can be cognitive, illustrated by a
tendency to think and act in a certain way or follow a rule of thumb. Biases
can also be emotional: a tendency to take action based on feeling rather than
fact.
Pulled from a study by H. Kent Baker and Victor Ricciardi that looks at how
biases impact investor behavior, here are eight biases that can affect
investment decisions: