17.2 Prospect Theory and Loss Aversion
4 min read•july 31, 2024
and shake up traditional economic thinking. They show we're not always rational with money. Instead, we're more scared of losing than excited about winning. This affects how we invest, shop, and even vote.
These ideas explain why we make weird choices sometimes. Like holding onto losing stocks too long or buying unnecessary warranties. They help us understand how framing choices as gains or losses can totally change our decisions.
Prospect Theory Principles
Core Concepts and Value Function
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- Prospect Theory developed by and in 1979 describes decision-making under risk and uncertainty
- Evaluates outcomes relative to a reference point rather than absolute terms
- Introduces S-shaped and asymmetric reflecting diminishing sensitivity to gains and losses
- Incorporates probability weighting overweighting small probabilities and underweighting moderate to high probabilities
- Challenges rational decision-making assumption in traditional economic models
- Distinguishes two decision-making phases editing (simplifying prospects) and evaluation (assessing edited prospects)
Departures from Traditional Models
- Explains phenomena unaccounted for in expected utility theory (, reflection effect, isolation effect)
- Incorporates psychological factors and into decision-making framework
- Demonstrates how framing of choices impacts decisions (gain vs. )
- Accounts for in loss domain and risk-averse behavior in gain domain
- Reveals preference reversals when identical options presented differently
Examples of Prospect Theory in Action
- choosing lower-risk, lower-return options due to loss aversion (bonds over stocks)
- resisting price increases more strongly than embracing equivalent price decreases
- Insurance purchases overinsuring against small risks (extended warranties) and underinsuring against large risks (catastrophic coverage)
- Labor market responses greater motivation from pay cut threats than equivalent bonus promises
Loss Aversion and Implications
Fundamentals of Loss Aversion
- Key principle stating people are more sensitive to losses than equivalent gains
- Loss aversion coefficient typically ranges from 1.5 to 2.5 (losses felt about twice as strongly as gains)
- Contributes to valuing owned items more highly than identical non-owned items
- Leads to status quo bias preferring current situation over potential losses from change
- Causes risk-seeking behavior in loss domain to avoid or recover losses
Impact on Financial Decisions
- Influences investor behavior holding losing stocks too long and selling winning stocks too quickly (disposition effect)
- Explains equity premium puzzle historically high stock returns compared to traditional risk-return models
- Affects asset allocation decisions favoring "safer" investments despite potentially lower long-term returns
- Impacts trading frequency leading to excessive trading during market downturns to recover losses
Consumer Behavior and Marketing Implications
- Exploited through framing effects in marketing presenting choices as potential losses to increase appeal
- Influences pricing strategies emphasizing potential savings or losses avoided
- Affects product positioning highlighting features that prevent losses (anti-aging creams, security systems)
- Shapes loyalty program design offering points that can be "lost" if not redeemed
- Impacts sales techniques using trial periods creating a sense of ownership and potential loss
Applying Prospect Theory
Investment and Financial Planning
- Explains preference for guaranteed returns over potentially higher but uncertain gains (certificates of deposit vs. stocks)
- Illuminates risk perception in portfolio construction overweighting of unlikely extreme events
- Guides financial advisor communication framing long-term investing as loss prevention strategy
- Informs retirement planning strategies emphasizing potential losses from inadequate savings
Consumer Decision Making
- Reveals asymmetric demand responses to price changes larger reaction to price increases than decreases
- Explains continuing investment in losing ventures to avoid realizing losses
- Influences product adoption rates faster adoption of products perceived as preventing losses (home security systems)
- Shapes subscription model effectiveness leveraging fear of losing access to services
Political and Social Applications
- Explains voting behavior greater motivation to prevent losses than achieve gains
- Informs policy communication framing proposals as loss prevention rather than gain acquisition
- Guides negotiation strategies emphasizing concessions as avoided losses rather than gained benefits
- Shapes public health campaigns focusing on risks of inaction rather than benefits of action (anti-smoking campaigns)
Limitations of Prospect Theory
Methodological Concerns
- Complexity of model makes practical application difficult in some situations
- Reliance on experimental data often from hypothetical scenarios questions real-world applicability
- Challenges in determining and measuring reference points which can be ambiguous or shifting
- Difficulty accounting for individual differences in risk preferences and decision-making styles
Contextual Limitations
- Focus on one-shot decisions limits applicability to repeated decision-making or long-term planning
- Questionable explanatory power for very high-stakes decisions or professional decision-makers
- Potential cultural bias in risk preferences and decision processes across different societies
- Limited consideration of emotional factors beyond basic loss aversion (regret, excitement)
Theoretical Challenges
- Debates over stability and formation of reference points crucial to theory's predictions
- Questions about integration with other economic and psychological theories of decision-making
- Ongoing discussions about the precise shape and parameters of the value and weighting functions
- Challenges in extending theory to multi-attribute decisions involving multiple gains and losses simultaneously
Key Terms to Review (19)
Amos Tversky: Amos Tversky was a renowned psychologist whose work significantly contributed to the understanding of human decision-making, particularly through the exploration of cognitive biases and heuristics. His research, often in collaboration with Daniel Kahneman, laid the groundwork for prospect theory, which explains how people perceive gains and losses differently, leading to behaviors such as loss aversion. Tversky's insights into human behavior challenged the traditional economic assumptions of rationality and have had profound implications in economics and psychology.
Bounded rationality: Bounded rationality refers to the concept that individuals make decisions based on limited information and cognitive limitations, leading to a simplification of complex problems. This means that while people strive to make rational choices, their ability to do so is constrained by the availability of information, time, and their cognitive processing capacity. As a result, individuals often rely on heuristics and face various cognitive biases, which can significantly influence their decision-making processes.
Certainty effect: The certainty effect refers to the tendency of individuals to give greater weight to outcomes that are certain compared to those that are probable, even if the expected value of the probable outcome is higher. This effect plays a significant role in decision-making, as it can lead people to favor guaranteed outcomes over potentially better but uncertain ones, highlighting a deviation from traditional rational choice theory.
Cognitive Biases: Cognitive biases are systematic patterns of deviation from norm or rationality in judgment, which can influence the way individuals perceive and interpret information. They can lead to illogical conclusions and affect decision-making processes, often resulting in choices that diverge from the expected utility model. Understanding cognitive biases is crucial as they relate to heuristics, influencing how people evaluate risks and rewards, particularly in uncertain situations.
Consumer Behavior: Consumer behavior refers to the study of how individuals make decisions to spend their available resources on consumption-related items. It encompasses the psychological, social, and economic factors that influence purchasing decisions, providing insights into how consumers evaluate alternatives, perceive value, and respond to marketing stimuli. Understanding consumer behavior helps businesses tailor their strategies to meet consumer needs and preferences effectively.
Daniel Kahneman: Daniel Kahneman is a renowned psychologist and Nobel laureate, recognized for his groundbreaking work in behavioral economics, particularly for his exploration of how psychological factors influence economic decision-making. His research, especially on cognitive biases and heuristics, reveals the often irrational ways people make choices, while his development of prospect theory highlights the impact of loss aversion on human behavior. Kahneman’s insights have led to a deeper understanding of how people navigate uncertainty and risk in their lives.
Endowment Effect: The endowment effect is a psychological phenomenon where people assign greater value to items merely because they own them. This tendency can lead individuals to overvalue their possessions, impacting their decision-making and economic behavior, particularly in contexts of loss aversion and perceived value.
Framing Effect: The framing effect refers to the phenomenon where individuals make different decisions based on how information is presented, rather than just on the information itself. This effect highlights the importance of choice architecture, as the way options are framed can significantly influence perceptions and behaviors, particularly in scenarios involving risk and uncertainty. Understanding the framing effect is crucial for analyzing how people respond to potential gains and losses, as it is deeply intertwined with concepts like loss aversion and prospect theory.
Gain framing: Gain framing refers to the way options are presented in terms of potential gains or benefits, influencing decision-making by highlighting positive outcomes. This approach aligns with the principles of prospect theory, where individuals tend to prefer choices that emphasize the likelihood of a positive outcome rather than focusing on negative aspects, which can alter risk perception and affect behavior.
Investment decisions: Investment decisions refer to the process of evaluating and selecting various investment opportunities based on potential returns and risks. These decisions are influenced by factors like market conditions, individual preferences, and behavioral biases, particularly in the context of how people perceive gains and losses.
Kahneman-Tversky Value Function: The Kahneman-Tversky value function is a crucial element of Prospect Theory that describes how people perceive gains and losses, emphasizing that losses typically have a greater emotional impact than equivalent gains. This function is concave for gains and convex for losses, illustrating that individuals are risk-averse when it comes to gains but risk-seeking when facing losses. The shape of this function highlights the concept of loss aversion, where the pain of losing is psychologically more powerful than the pleasure of gaining the same amount.
Loss aversion: Loss aversion is a psychological principle that describes how people tend to prefer avoiding losses rather than acquiring equivalent gains. This concept highlights that the pain of losing something is psychologically more impactful than the pleasure of gaining something of equal value. Understanding this behavior helps explain why individuals often make decisions that are risk-averse, particularly in uncertain situations involving potential gains and losses.
Loss framing: Loss framing is a cognitive bias that emphasizes the negative outcomes of a decision or situation, highlighting what an individual stands to lose rather than gain. This approach can significantly influence people's choices and behaviors, often leading to risk-averse behavior when faced with potential losses compared to potential gains. By presenting information in a way that stresses losses, individuals may react differently than if the same information were framed around potential benefits.
Probability Weighting Function: The probability weighting function is a key concept in decision-making under risk that describes how individuals perceive the likelihood of different outcomes. Rather than treating probabilities linearly, this function reflects the tendency for people to overweight low probabilities and underweight high probabilities, leading to inconsistencies in risk assessment. This behavior connects to prospect theory, where the subjective value of outcomes is influenced by their perceived likelihood, impacting choices involving gains and losses.
Prospect Theory: Prospect theory is a behavioral economic theory that describes how people make decisions involving risk and uncertainty, particularly emphasizing that individuals value potential gains and losses differently. This theory suggests that people are generally more sensitive to losses than to gains, leading to a phenomenon known as loss aversion. This concept plays a crucial role in understanding decision-making, especially in contexts where individuals face uncertain outcomes and highlights the importance of framing and presentation of choices.
Reference Dependence: Reference dependence is a behavioral economics concept that suggests individuals evaluate outcomes relative to a specific reference point rather than in absolute terms. This means that people assess gains and losses based on their current situation or expectations, leading to behaviors that may deviate from traditional economic predictions. The significance of this idea is particularly evident in how individuals exhibit loss aversion, demonstrating a stronger reaction to losses compared to equivalent gains.
Risk-seeking behavior: Risk-seeking behavior refers to the tendency of individuals to prefer options that involve higher risk in exchange for potentially higher rewards. This behavior contrasts with risk-averse tendencies where individuals prefer certainty and lower-risk options. In decision-making scenarios, individuals exhibiting risk-seeking behavior may overvalue potential gains and underweight potential losses, influencing their choices significantly.
Sunk cost fallacy: The sunk cost fallacy is a cognitive bias that occurs when individuals continue to invest in a decision based on previously invested resources (time, money, effort) rather than current and future benefits. This fallacy highlights the irrational behavior of allowing past costs to influence ongoing decision-making, often leading to poor choices as people strive to avoid perceived losses, even when the rational option would be to cut their losses.
Value function: The value function is a central concept in Prospect Theory that describes how individuals perceive gains and losses, showing that people tend to evaluate outcomes relative to a reference point rather than in absolute terms. This function is typically concave for gains and convex for losses, indicating that the pain of losing is felt more intensely than the pleasure of an equivalent gain. The value function captures the essence of loss aversion, which suggests that losses weigh more heavily on decision-making compared to gains.