Prospect Theory: What It Is and How It Works, With Examples

What Is the Prospect Theory?

Prospect theory assumes that losses and gains are valued differently, and thus individuals make decisions based on perceived gains instead of perceived losses. Also known as the "loss-aversion" theory, the general concept is that if two choices are put before an individual, both equal, with one presented in terms of potential gains and the other in terms of possible losses, the former option will be chosen.

How the Prospect Theory Works

Prospect theory belongs to the behavioral economic subgroup, describing how individuals make a choice between probabilistic alternatives where risk is involved and the probability of different outcomes is unknown. This theory was formulated in 1979 and further developed in 1992 by Amos Tversky and Daniel Kahneman, deeming it more psychologically accurate of how decisions are made when compared to the expected utility theory.

The underlying explanation for an individual’s behavior, under prospect theory, is that because the choices are independent and singular, the probability of a gain or a loss is reasonably assumed as being 50/50 instead of the probability that is actually presented. Essentially, the probability of a gain is generally perceived as greater.

Tversky and Kahneman proposed that losses cause a greater emotional impact on an individual than does an equivalent amount of gain, so given choices presented two ways—with both offering the same result—an individual will pick the option offering perceived gains.

For example, assume that the end result of receiving $25. One option is being given $25 outright. The other option is being given $50 and then having to give back $25. The utility of the $25 is exactly the same in both options. However, individuals are most likely to choose to receive straight cash because a single gain is generally observed as more favorable than initially having more cash and then suffering a loss.

Phases of Prospect Theory

Prospect theory asserts that decisions are made through a two-stage process. Instead of considering all available information and possible options (which would be impossible) humans use a two-step process to narrow down the most important information. These steps are described as the editing phase and the evaluation phase.

The Editing Phase

The editing phase is where people decide which information will be used in the evaluation stage. Decision-makers will use mental shortcuts to assess which information is important, and what options are available. They also decide which outcomes are most desirable, and even rank their priorities.

The editing phase is important because it can introduce biases that emerge later in the decision process. If an individual does not consider certain unlikely outcomes or makes an incorrect assessment of that outcome's probability, they may end up making sub-optimal decisions later on.

The Evaluation Phase

This is the stage where people make their final decisions, based on the assessments made in the editing phase. People weigh the probability of each outcome and take actions based on the perceived likelihood and desirability of each outcome.

It is important to note that these decisions are not necessarily based on rational calculations. Prospect theory posits that people tend to be risk-averse when the stakes are high, and risk-accepting when the stakes are low. In other words, they tend to make choices that minimize losses rather than maximize expected gains.

Characteristics of Prospect Theory

Prospect theory suggests that humans tend to prefer certainties over probabilities. For example, suppose that you have a choice between being given $50, and a 50% chance of winning $100. Most people will take the $50, even though the expected value of the two options is exactly the same.

Prospect theory also asserts that people underestimate (or even ignore) outcomes with a low probability. Consequently, they also tend to overestimate the probability of likely events, resulting in a bias that neglects improbable outcomes. This is particularly relevant to investors, who must consider the possibility of unforeseen black swan events.

How To Overcome Biases

Understanding prospect theory can help individuals overcome their biases and make more rational choices. For example, an investor who is aware of their bias towards high-probability events can compensate by giving extra consideration to low-probability ones.

It also helps to reframe possible outcomes in a way that reduces the impact of cognitive biases. Instead of thinking in terms of gain or loss, you can instead think in terms of the value of expected outcomes, without using the present as a reference point. This can reduce one's loss-aversion bias.

Outcomes

According to Tversky and Kahneman, the certainty effect is exhibited when people prefer certain outcomes and underweigh outcomes that are only probable. The certainty effect leads to individuals avoiding risk when there is a prospect of a sure gain. It also contributes to individuals seeking risk when one of their options is a sure loss.

The isolation effect occurs when people have presented two options with the same outcome, but different routes to the outcome. In this case, people are likely to cancel out similar information to lighten the cognitive load, and their conclusions will vary depending on how the options are framed.

Example of Prospect Theory

Consider an investor who is given two pitches for the same mutual fund. The first advisor presents the fund to Sam, highlighting that it has an average return of 10% for the last three years. Meanwhile, a second advisor tells the investor that the fund has had above-average returns over the last decade, but has been in decline for the last three years.

Prospect theory says that although the investor has been pitched the exact same mutual fund, they are likely to buy from the first advisor. That is, the investor is more likely to buy the fund from the advisor that expresses the fund's rate of return in terms of only gains, while the second advisor presented the fund as having high returns, but also losses.

The Bottom Line

Prospect theory says that individuals will accept an investment when the gains are presented, versus the losses. That is, investors weigh potential gains more than potential losses.