4.1 Foundations of Prospect Theory
3 min read•july 25, 2024
Prospect theory revolutionized our understanding of decision-making under risk. It challenges traditional economic models by incorporating psychological factors that influence how we perceive and respond to potential gains and losses.
Key principles like reference points, , and explain why people often make choices that seem irrational. These insights have profound implications for fields ranging from finance to public policy, helping us better predict and understand human behavior.
Foundations of Prospect Theory
Key principles of prospect theory
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- dependency
- Outcomes evaluated as gains or losses relative to reference point shapes decision-making
- Reference point typically status quo but can shift based on expectations or goals (salary, investment returns)
- Loss aversion
- Losses psychologically impact individuals more than equivalent gains motivates risk-averse behavior
- People feel losses about twice as strongly as gains of same magnitude (100 gain pleases)
- Diminishing sensitivity
- Marginal value of gains and losses decreases with magnitude affects risk preferences
- S-shaped illustrates diminishing impact (20 feels larger than 1010)
- Probability weighting
- People overweight small probabilities and underweight large probabilities distorts decision-making
- Inverse S-shaped probability weighting function explains lottery ticket purchases and insurance decisions
- Framing effects
- Presentation of choices influences decision-making through cognitive biases
- Same outcome perceived differently based on framing impacts risk attitudes (95% survival rate vs 5% mortality rate)
Prospect theory vs expected utility theory
- Utility vs value
- Expected utility theory uses utility function to measure satisfaction from outcomes
- Prospect theory employs value function based on gains and losses relative to reference point
- Probability treatment
- Expected utility theory uses objective probabilities in calculations
- Prospect theory applies decision weights to probabilities accounting for cognitive biases
- Risk attitudes
- Expected utility theory assumes consistent risk preferences across all scenarios
- Prospect theory allows for risk-seeking behavior in losses explains gambling to recover losses
- Reference dependence
- Expected utility theory ignores reference points focuses solely on final outcomes
- Prospect theory incorporates reference-dependent preferences captures importance of context
- Rationality assumptions
- Expected utility theory assumes perfectly rational decision-makers
- Prospect theory accounts for cognitive biases and heuristics reflects real-world behavior
Components of prospect theory
- Value function
- S-shaped curve reflects diminishing sensitivity to gains and losses
- Steeper for losses than gains illustrates loss aversion
- Concave for gains, convex for losses shows risk aversion in gains, risk-seeking in losses
- Passes through reference point at origin emphasizes importance of reference dependence
- Probability weighting function
- Inverse S-shaped curve captures overweighting of small probabilities, underweighting of large probabilities
- Overweights low probabilities explains attraction to lotteries
- Underweights high probabilities leads to risk-seeking behavior in losses
- Decision weights replace objective probabilities in prospect evaluation
- Editing phase
- Simplification of prospects reduces cognitive load
- Combination of similar outcomes streamlines decision-making
- Segregation of riskless components isolates certain gains or losses
- Evaluation phase
- Application of value function and decision weights to edited prospects
- Calculation of overall prospect value determines choice between alternatives
Psychological factors in risk decisions
- Cognitive biases
- leads to overestimation of familiar or recent events (plane crashes)
- causes neglect of base rates in probability judgments (stereotyping)
- Anchoring and adjustment results in insufficient adjustment from initial estimates (negotiation)
- Emotional factors
- Regret aversion motivates choices that minimize potential regret (sticking with status quo)
- Disappointment aversion leads to lowered expectations to avoid negative emotions
- Anticipatory emotions influence decisions based on expected future feelings (anxiety, excitement)
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- Categorization of financial outcomes affects spending and saving behavior
- Integration or segregation of gains and losses impacts risk preferences (house money effect)
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- Overweighting of certain outcomes relative to probable ones leads to risk aversion (sure gain vs probable larger gain)
- Reflection effect
- Risk aversion in gains, risk-seeking in losses explains different behaviors in different domains
- Isolation effect
- Focus on distinguishing features between options neglects shared characteristics
- Can lead to inconsistent preferences when options are presented differently
Key Terms to Review (18)
Amos Tversky: Amos Tversky was a pioneering psychologist known for his groundbreaking work in cognitive psychology and behavioral finance, particularly in decision-making under uncertainty. He, alongside Daniel Kahneman, developed key concepts that explain how people make financial decisions that deviate from traditional economic theories, thereby reshaping our understanding of human behavior in financial contexts.
Availability Heuristic: The availability heuristic is a mental shortcut that relies on immediate examples that come to a person's mind when evaluating a specific topic, concept, method, or decision. It often leads individuals to overestimate the likelihood of events based on how easily they can recall instances of those events, impacting decision-making processes in various financial contexts.
Behavioral Portfolio Theory: Behavioral Portfolio Theory is an investment framework that integrates behavioral finance concepts into portfolio management, emphasizing how investors' psychological biases influence their asset allocation decisions. This theory suggests that individuals construct portfolios not just based on expected returns and risks, but also in response to their emotions, cognitive biases, and the desire to achieve specific goals or psychological satisfaction.
Certainty Effect: The certainty effect is a phenomenon in behavioral finance where individuals disproportionately favor certain outcomes over uncertain ones, even when the uncertain option may have a higher expected value. This tendency demonstrates how people often make decisions based on perceived certainty rather than purely on statistical likelihoods. Understanding the certainty effect helps in analyzing how individuals assess risk and reward, particularly in the context of potential gains and losses.
Daniel Kahneman: Daniel Kahneman is a psychologist known for his groundbreaking work in the field of behavioral finance and for developing the concept of Prospect Theory, which explores how people make decisions under uncertainty. His research highlights the cognitive biases that influence financial decision-making and contrasts traditional economic theories based on rationality.
Efficient Market Hypothesis: The Efficient Market Hypothesis (EMH) is a financial theory stating that asset prices reflect all available information, making it impossible for investors to consistently achieve higher returns than average market returns on a risk-adjusted basis. This idea connects with various concepts such as investor behavior, market anomalies, and valuation models that challenge or support its validity.
Emotional Bias: Emotional bias refers to the influence of personal feelings and emotions on an individual's decision-making processes. This type of bias can lead to irrational financial decisions as emotions like fear, greed, and overconfidence can overshadow logical analysis, impacting investment choices and risk assessment. Understanding emotional bias is crucial for grasping how psychological factors shape economic behaviors, particularly in high-stakes situations.
Endowment Effect: The endowment effect is a psychological phenomenon where people assign more value to things simply because they own them. This leads to irrational decision-making and can significantly influence behaviors in various financial contexts, such as investment and consumer choices, highlighting the biases that deviate from traditional economic theory.
Framing Effect: The framing effect refers to the way information is presented or 'framed' that can significantly influence individuals' decisions and judgments. This psychological phenomenon reveals that people's choices can vary based on how options are described, highlighting the importance of context in decision-making processes.
Loss Aversion: Loss aversion is the psychological phenomenon where individuals prefer to avoid losses rather than acquiring equivalent gains, meaning the pain of losing is psychologically more impactful than the pleasure of gaining. This concept significantly influences various financial behaviors and decisions, shaping how investors perceive risks and rewards.
Losses Loom Larger than Gains: The concept that individuals tend to feel the pain of losses more intensely than the pleasure of equivalent gains. This principle is central to understanding how people make decisions under uncertainty, emphasizing that the emotional impact of losing money is more significant than that of gaining the same amount. This idea is fundamental in explaining various behaviors observed in financial markets and personal finance decisions.
Mental Accounting: Mental accounting refers to the cognitive process where individuals categorize, evaluate, and keep track of their financial resources in separate mental 'accounts'. This concept explains how people treat money differently depending on its source or intended use, which can lead to irrational financial behaviors and decision-making.
Overconfidence Bias: Overconfidence bias is a cognitive bias where individuals overestimate their own abilities, knowledge, or predictions, leading to overly optimistic beliefs about future outcomes. This bias often affects decision-making processes, causing investors and managers to take on excessive risks, misjudge market conditions, or disregard contradictory information.
Probability Weighting: Probability weighting is a concept from behavioral finance that describes how individuals perceive the likelihood of outcomes in decision-making under risk. People tend to overestimate the probability of unlikely events and underestimate the probability of more likely events, leading to skewed perceptions that can influence choices. This bias affects the way risks are assessed and decisions are made, particularly in the context of gains and losses.
Rational Actor Model: The rational actor model is a theoretical framework used to understand decision-making processes, where individuals are assumed to act in a way that maximizes their utility based on available information. This model posits that people weigh the potential benefits and costs of their choices, leading to logical and consistent outcomes. It serves as a baseline for understanding how individuals should make decisions, though it often contrasts with behavioral insights that highlight the emotional and cognitive biases influencing real-life choices.
Reference Point: A reference point is a baseline or standard used to compare outcomes, helping individuals evaluate potential gains and losses. This concept is central to understanding how people perceive value, make decisions under uncertainty, and assess the worth of different options. Reference points play a significant role in shaping preferences and behaviors, particularly when individuals encounter situations that involve risk or uncertainty.
Representativeness heuristic: The representativeness heuristic is a mental shortcut that relies on comparing the likelihood of an event or object to a prototype in our minds, which can lead to misjudgments about probabilities and outcomes. This cognitive bias often influences decision-making by causing individuals to overlook relevant statistical information and rely too heavily on similarities to past experiences or stereotypes, affecting perceptions in various financial contexts.
Value Function: The value function is a central concept in Prospect Theory that describes how individuals evaluate potential gains and losses. It illustrates that people perceive losses as more significant than equivalent gains, which leads to risk-averse behavior when dealing with gains and risk-seeking behavior when facing losses. This function is typically concave for gains and convex for losses, highlighting the asymmetrical way people perceive value.