Introduction to Prospect Theory

Introduction

• Prospect theory is a behavioural economics theory developed by Daniel Kahneman and Amos Tversky in 1979.

• This challenged a traditional economic theory, known as Expected Utility Theory. It assumed that people always made rational decisions to maximise expected outcomes.

• However, in a world of constant uncertainty and risk, people tend to be more driven by their emotions, weighing up the potential gains and losses, which in turn influence their behaviour when making decisions.

Key Ideas

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Loss Aversion

• When people expect to gain, they become risk-averse, avoiding potential losses. When people expect to lose, they become risk-seeking, chasing potential gains.

• However, individuals value gains and losses differently, losses feel more painful than the satisfaction gained from an equivalent win.

• When faced with neither, people will mostly make choices to avoid losses even at the cost of possible gains.

Reference Dependence

• People evaluate outcomes relative to a specific context rather than considering the absolute big picture. This reference point is often shaped by expectations and past experiences.

• Individuals perceive outcomes as gains and losses subjectively, rather than objectively assessing its value entirely.

• This again links to why individuals treat gains and losses differently, a loss still feels worse than a gain feels good.

Diminishing Sensitivity

• As the size of a gain or loss increases, its psychological impact becomes less intense.

• The difference between $100 and $200 feels more significant than the difference between $100,100 and $100,200, even though both involve a $100 change.

• This principle again impacts how gains and losses are valued. Gaining $10 feels much stronger than a $10 increase when you already have $1000 and vice versa.

Probability Weighting

• People perceive probabilities in a non-linear way.

• Instead of treating probabilities fairly, people overweight and give too much importance to small probabilities and underweight large probabilities because they do not fully trust it.

• Probability weighting follows a pattern: people are too optimistic about rare events but too skeptical about likely events.

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Critiques

Oversimplification of decision making

• Prospect Theory suggests that people make decisions based on relative gains and losses compared to a reference point, with losses being felt more intensely than equivalent gains.

• Critics argue that this oversimplifies the complexity of human decision-making. People's decisions may be influenced by a wider range of factors such as emotions, cognitive biases, and external circumstances, which aren't fully captured by the theory.

No clear prediction for risk preferences

• Prospect Theory does not provide a definitive rule for how people will behave in all situations. In certain contexts, it predicts risk-seeking behaviour (e.g., in losses) and in others, risk-averse behaviour (e.g., in gains).

• However, it doesn't always offer a clear mechanism to predict exactly when and why people will be risk-averse versus risk-seeking, leaving a gap in its explanatory power.

Limited empirical support

• Some have criticised Prospect Theory for being overly descriptive rather than predictive. While the theory has been successful in explaining some real-world behaviours (such as the disposition effect in trading), there are instances where it fails to predict actual choices in experimental settings or when compared to more traditional utility theory models.

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Applications – Why is this important? How does this apply to real life?

Why is this important?

For students seeking to pursue Politics, Philosophy & Economics (PPE) at university, prospect theory helps explain how individuals make decisions under uncertainty and risk and is particularly useful in understanding human behaviour in various areas of PPE. Delving into prospect theory can suggest:

• Initiative in exploring economic theories and models

• Strong quantitative and analytical skills

• Ability to apply economic concepts to real-world problems

• A deeper curiosity about economic decision-making and its societal impacts

Application of Prospect Theory in Finance: The Disposition Effect

The Disposition Effect – Investors tend to hold onto losing stocks too long and sell winning stocks too quickly, contrary to rational investment strategies.

Prospect Theory Link:

• Loss aversion: Investors feel losses more strongly than equivalent gains, making them reluctant to sell depreciating assets.

• Reference dependence: Investors compare current stock prices to their purchase price (reference point), rather than objectively evaluating future prospects.

Real-World Impact:

• Leads to inefficient portfolio management, as investors may miss out on gains by selling too early or accumulate larger losses by refusing to sell.

• Causes market anomalies, such as the "January effect," where stock prices tend to rise at the beginning of the year as investors finally sell off losses for tax purposes

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Further Reading

• Richard H. Thaler – Misbehaving: The Making of Behavioral Economics

  • As recommended by LSE students

• The Oxford Handbook of Women and the Economy – Gender Differences in Behavioural Traits and Labour Market Outcomes

  • Applies loss aversion and probability weighting in order to explain gendered economic outcomes.