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Prospect theory


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Traditionally, it is believed the net effect of the gains and losses involved with each choice are combined to present an overall evaluation of whether a choice is desirable. Academics tend to use "utility" to describe enjoyment and contend that we prefer instances that maximize our utility. However, research has found that we don't actually process information in such a rational way. In 1979, Kahneman and Tversky presented an idea called prospect theory, which contends that people value gains and losses differently, and, as such, will base decisions on perceived gains rather than perceived losses. Thus, if a person were given two equal choices, one expressed in terms of possible gains and the other in possible losses, people would choose the former - even when they achieve the same economic end result. According to prospect theory, losses have more emotional impact than an equivalent amount of gains. 

 For example, in a traditional way of thinking, the amount of utility gained from receiving $50 should be equal to a situation in which you gained $100 and then lost $50. In both situations, the end result is a net gain of $50. However, despite the fact that you still end up with a $50 gain in either case, most people view a single gain of $50 more favorably than gaining $100 and then losing $50. 

 Kahneman and Tversky conducted a series of studies in which subjects answered questions that involved making judgments between two monetary decisions that involved prospective losses and gains. For example, the following questions were used in their study: 

 You have $1,000 and you must pick one of the following choices: 

  • Choice A: You have a 50% chance of gaining $1,000, and a 50% chance of gaining $0. 
  • Choice B: You have a 100% chance of gaining $500. 
You have $2,000 and you must pick one of the following choices: 
  • Choice A: You have a 50% chance of losing $1,000, and 50% of losing $0. 
  • Choice B: You have a 100% chance of losing $500.
If the subjects had answered logically, they would pick either "A" or "B" in both situations. (People choosing "B" would be more risk adverse than those choosing "A"). However, the results of this study showed that an overwhelming majority of people chose "B" for question 1 and "A" for question 2. The implication is that people are willing to settle for a reasonable level of gains (even if they have a reasonable chance of earning more), but are willing to engage in risk-seeking behaviors where they can limit their losses. In other words, losses are weighted more heavily than an equivalent amount of gains. 




The prospect theory can be used to explain quite a few illogical financial behaviors. For example, there are people who do not wish to put their money in the bank to earn interest or who refuse to work overtime because they don't want to pay more taxes. Although these people would benefit financially from the additional after-tax income, prospect theory suggests that the benefit (or utility gained) from the extra money is not enough to overcome the feelings of loss incurred by paying taxes. (...) 

Thanks to  IPE class
Source: www.investopedia.com

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