Prospect theory posits that individuals assess losses and gains differently, leading them to make decisions based on perceived gains rather than perceived losses.
Often referred to as the “loss-aversion” theory, it suggests that when presented with two equal choices—one framed in terms of potential gains and the other in terms of possible losses—individuals tend to opt for the former.
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How Does Prospect Theory Work on the Emotions?
In behavioral economics, prospect theory delves into how people choose between probabilistic alternatives where risk is involved and outcomes’ probabilities are uncertain. Developed in 1979 and further refined in 1992 by Amos Tversky and Daniel Kahneman, prospect theory offers a psychologically accurate framework for understanding decision-making compared to traditional expected utility theory.
At its core, prospect theory assumes that individuals perceive the probability of gains and losses as roughly equal, even if actual probabilities differ. Moreover, it suggests that losses have a more significant emotional impact than equivalent gains. Consequently, when presented with choices offering the same net outcome but framed differently, individuals tend to prefer options emphasizing gains.
For instance, consider a scenario where one option receives $25 outright, while the other involves receiving $50 initially but then giving back $25. Despite the identical net outcome, individuals are likely to choose the first option due to the perception of a single gain being more favorable than the potential loss in the second option.
Emotional States & Their Influence on Loss Aversion
Emotions do not merely color our perceptions — they actively shift how we weight losses versus gains. Research shows that feelings such as sadness tend to increase risk aversion in the domain of gains, whereas emotions like anger can reduce loss aversion by weakening the emotional pain associated with potential loss.
When investors face market volatility, their prevailing mood can intensify or dampen the psychological impact of price drops — meaning that two individuals with identical portfolios might react very differently under the same market stress, purely because of emotional variance. Embedding awareness of emotional fluctuations into investment strategy can help mitigate bias from over‑reacting or under‑reacting during critical decision moments.
Phases of Prospect Theory
Prospect theory unfolds in two stages: the editing phase and the evaluation phase. During the editing phase, decision-makers select which information to consider and which outcomes are most desirable, often relying on mental shortcuts and biases. This phase lays the groundwork for the evaluation phase, where final decisions are made based on the perceived likelihood and desirability of each outcome.
While decisions under prospect theory are not necessarily rational, they tend to reflect risk-aversion in high-stakes scenarios and risk-acceptance in low-stakes situations. Individuals prioritize minimizing losses over maximizing expected gains.
Characteristics of Prospect Theory
Prospect theory suggests that people exhibit a preference for certainties over probabilities, often opting for certain outcomes even when statistically equivalent options are available. Additionally, individuals tend to underestimate low-probability outcomes and overestimate the likelihood of probable events, leading to biases that neglect improbable outcomes. This tendency is particularly relevant in investment contexts, where unforeseen events can significantly impact outcomes.
Overcoming Biases
Understanding prospect theory can empower individuals to mitigate biases and make more rational choices. For instance, investors aware of their inclination towards high-probability events can consciously consider low-probability outcomes. Reframing potential outcomes without anchoring them to the present can also help reduce loss-aversion bias.
Example of Prospect Theory
Imagine an investor presented with two pitches for the same mutual fund. The first advisor emphasizes the fund’s average return of 10% over the last three years, while the second highlights its above-average returns over the past decade, albeit with recent declines. Prospect theory suggests that the investor is more likely to choose the first advisor’s pitch, which focuses on gains rather than losses.
Disposition Effect & Framing in Action
A key real‑world manifestation of prospect theory in investing is the disposition effect: the tendency to sell winning assets too early while holding onto losing ones longer than rational models would suggest.This behavior is driven by our stronger emotional resistance to admitting losses and our desire to lock in gains.
Moreover, framing effects influence how we perceive prospects: the same investment outcome framed as a “gain” or “loss” can lead to radically different choices. Investors who understand how reference points shift and how framing biases choices are better equipped to push past emotional anchors and make decisions more aligned with long‑term value.
In Summary
Prospect theory elucidates how individuals prioritize gains over losses when making decisions. It underscores the psychological and emotional factors influencing decision-making and offers insights into biases and preferences that shape choices in uncertain environments. By understanding prospect theory, investors can navigate decision-making processes more effectively, ultimately improving their outcomes.
