💳Behavioral Finance Unit 4 – Prospect Theory: Decisions Under Risk

Key Concepts

• Prospect theory is a behavioral economic theory that describes how people make decisions under risk and uncertainty
• Developed by Daniel Kahneman and Amos Tversky in 1979 as an alternative to expected utility theory
• Introduces the concept of reference points, which are the starting points people use to evaluate potential gains and losses
• Proposes that people are loss averse, meaning they feel the pain of losses more intensely than the pleasure of equivalent gains
  • For example, the disappointment of losing $100 is greater than the joy of winning$100
• Suggests that people overweight small probabilities and underweight large probabilities when making decisions
• Incorporates the idea of diminishing sensitivity, where the difference between $100 and$200 feels larger than the difference between $1,100 and$1,200
• Explains why people may make seemingly irrational decisions that deviate from the predictions of traditional economic models

Historical Context

• Prospect theory emerged as a response to the limitations of expected utility theory, which was the dominant model for decision-making under risk at the time
• Expected utility theory assumed that people make rational decisions based on the expected value of outcomes, but it failed to explain many observed behaviors
• Kahneman and Tversky drew inspiration from psychological research on heuristics and biases to develop a more descriptive model of decision-making
• The theory was first presented in a 1979 paper titled "Prospect Theory: An Analysis of Decision under Risk"
• Kahneman and Tversky continued to refine and expand the theory in subsequent works, such as "Advances in Prospect Theory" (1992)
• Kahneman was awarded the Nobel Memorial Prize in Economic Sciences in 2002 for his contributions to behavioral economics, including prospect theory
• The development of prospect theory marked a significant shift in economic thinking, challenging the assumption of perfect rationality and incorporating psychological insights into economic models

Cognitive Biases

• Prospect theory helps explain several cognitive biases that influence decision-making under risk
• Loss aversion bias causes people to prefer avoiding losses to acquiring equivalent gains
  • This can lead to risk-averse behavior when facing potential gains and risk-seeking behavior when facing potential losses
• Framing effect occurs when people's decisions are influenced by how information is presented (framed) as either a gain or a loss
  • For example, a medical treatment with a 90% survival rate may be perceived more favorably than one with a 10% mortality rate, even though they are mathematically equivalent
• Endowment effect causes people to value items they own more highly than identical items they do not own
• Status quo bias leads people to prefer maintaining their current state over making changes, even when the alternative may be more beneficial
• Anchoring bias occurs when people rely too heavily on an initial piece of information (the anchor) when making decisions or estimates
• Availability bias causes people to overestimate the likelihood of events that are easily remembered or imagined
• These biases can lead to suboptimal decision-making and deviations from the predictions of traditional economic models

Decision-Making Process

• Prospect theory proposes a two-stage decision-making process: editing and evaluation
• In the editing stage, people simplify and organize the available information
  • They identify the reference point, which is typically their current state or the status quo
  • They categorize outcomes as gains or losses relative to the reference point
  • They may also apply mental accounting, separating decisions into distinct accounts rather than considering their overall impact
• In the evaluation stage, people assess the value of each potential outcome and choose the option with the highest subjective value
  • The value function is concave for gains and convex for losses, reflecting diminishing sensitivity
  • The value function is steeper for losses than for gains, reflecting loss aversion
  • People assign decision weights to each outcome based on their probability, but these weights do not always correspond to objective probabilities
    • Small probabilities are often overweighted, while large probabilities are underweighted
• The combination of the value function and decision weights leads to the characteristic S-shaped curve of prospect theory
• People's final decisions may not always align with the predictions of expected utility theory, as they are influenced by the subjective values and decision weights assigned in the evaluation stage

Real-World Applications

• Prospect theory has been applied to various real-world contexts to explain and predict decision-making behavior
• In finance, prospect theory helps explain investor behavior, such as the disposition effect (the tendency to sell winning investments too early and hold losing investments too long)
  • It also sheds light on the equity premium puzzle, which is the observation that stocks have historically outperformed bonds by a larger margin than can be explained by traditional risk-return models
• In insurance, prospect theory can explain why people may be willing to pay more for insurance than the expected value of their losses, as they overweight the small probability of a large loss
• In marketing, prospect theory is used to design effective pricing strategies and frame product offerings in terms of gains or losses to influence consumer behavior
  • For example, a "buy one, get one free" promotion may be more attractive than a "50% off" discount, even if the net price is the same
• In public policy, prospect theory can inform the design of incentives and penalties to encourage desired behaviors or discourage undesired ones
  • For instance, framing a tax as a "loss" rather than a "cost" may make it more effective in reducing consumption of a harmful product
• In negotiation and conflict resolution, understanding the principles of prospect theory can help parties reach mutually beneficial agreements by framing proposals in terms of gains rather than losses

Critiques and Limitations

• While prospect theory has greatly enhanced our understanding of decision-making under risk, it is not without its critiques and limitations
• Some researchers argue that the theory is too complex and lacks parsimony compared to expected utility theory
  • The number of parameters in prospect theory can make it difficult to estimate and apply in practice
• The theory relies heavily on the concept of reference points, but determining an individual's reference point in a given situation can be challenging
  • Reference points may also be subject to change over time or across contexts
• Prospect theory does not fully account for the role of emotions in decision-making, which can have a significant impact on risk preferences and behavior
• The theory focuses primarily on individual decision-making and may not always translate well to group or organizational contexts
• Some studies have found that the specific patterns predicted by prospect theory, such as the reflection effect (risk aversion for gains and risk-seeking for losses), do not always hold in empirical data
• The theory does not provide a clear prescription for how people should make decisions, as it is primarily descriptive rather than normative
• Despite these limitations, prospect theory remains a valuable framework for understanding and predicting decision-making behavior under risk

Comparison to Traditional Finance

• Prospect theory challenges several key assumptions of traditional finance models, such as expected utility theory and the efficient market hypothesis
• Traditional finance assumes that investors are rational and risk-averse, always seeking to maximize their expected utility
  • Prospect theory, on the other hand, recognizes that people's risk preferences can vary depending on whether they face gains or losses
• Traditional finance models often assume that investors have consistent risk preferences, but prospect theory suggests that risk attitudes can change based on the reference point and framing of outcomes
• The efficient market hypothesis posits that market prices reflect all available information and that investors cannot consistently outperform the market
  • Prospect theory, however, suggests that investors may exhibit irrational behaviors that can lead to market anomalies and mispricing
• Traditional finance relies heavily on the use of probability distributions to model uncertainty, while prospect theory emphasizes the role of decision weights that may not correspond to objective probabilities
• Prospect theory helps explain some of the anomalies and puzzles that traditional finance models struggle to account for, such as the equity premium puzzle and the disposition effect
• Incorporating insights from prospect theory into traditional finance models can lead to a more comprehensive understanding of investor behavior and market dynamics
  • For example, some researchers have proposed modified versions of the capital asset pricing model (CAPM) that incorporate loss aversion and reference-dependent preferences

Future Directions

• Despite its significant contributions, prospect theory remains an active area of research with many potential avenues for future development
• One important direction is the further integration of prospect theory with other branches of behavioral economics and psychology, such as the study of emotions, social influences, and learning
  • This can help provide a more comprehensive understanding of decision-making under risk and uncertainty
• Researchers are also working on extending prospect theory to more complex decision contexts, such as multi-attribute choices, dynamic environments, and strategic interactions
  • This may involve developing new mathematical models or adapting existing ones to incorporate the insights of prospect theory
• Another area of focus is the application of prospect theory to the design of decision support systems and tools that can help people make better choices under risk
  • This could include the development of interactive visualizations, personalized recommendation systems, or choice architecture interventions that leverage the principles of prospect theory
• Researchers are also exploring the neural and physiological underpinnings of prospect theory, using techniques from neuroscience and psychophysiology to study how the brain processes risk and uncertainty
  • This can help provide a more complete picture of the psychological mechanisms underlying decision-making and inform the development of new theories and models
• Finally, there is ongoing work on testing and refining the predictions of prospect theory using both experimental and observational data from a variety of domains, such as finance, health, and public policy
  • This empirical research is crucial for validating and improving the theory, as well as identifying its boundary conditions and limitations