What Is Prospect Theory?

By: Flabia Maharjan

Prospect Theory Definition

Prospect theory was developed by Daniel Kahneman and Amos Tversky in 1979. The foundation of this theory is that we value losses and gains quite differently. In other words, people prioritize avoiding losses over similar gains because losses cause a greater psychological impact on individuals than gains.

Prospect Theory Explained

Prospect Theory showcases the biasness towards profits over losses, which is a general human tendency. It says that if individuals are presented with two choices, one in terms of potential gains and the other in terms of potential losses with a 50-50 probability each, people would choose the former. Hence, people value profits and losses quite differently, which leads them to make decisions based on perceived gains rather than perceived losses.

Generally known as the loss aversion theory, prospect theory is a part of behavioral finance that conveys the decision-making attitudes of people in risk involving situations. It tells us how people assess risk and reward during financial transactions like investing. Prospect theory holds that people often avoid losses rather than seek profit. And this is because losses are considered to have a greater emotional impact in comparison to gains.

For instance, you give Rs 1000 to a stranger for free. Soon after, you offer to flip a coin, and depending upon the side they have selected, they could either make twice the money, i.e., Rs 2000, or end up with zero rupees. In such a case, most people would decline to flip the coin. Psychologically, the fear of losing the 1000 rupees is greater than the happiness of winning Rs 2000. This gets us to the core of prospect theory, which states that people are more sensitive towards losses than gains.

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Factors Affecting Decision-Making In Prospect Theory

1. Certainty

When individuals are given several options to choose from, they generally tend to go for a certain option. It means a person is willing to forgo an option that provides more income to achieve more certainty.

Prospect theory covers two certainties. They are the certainty of gain and the certainty of loss. Prospect theory highlights the risk-averse nature of individuals when they come across a certain gain. It means when individuals face a potential gain, they will choose a definite gain over a risk that will yield a greater reward/gain.

However, when an individual faces a potential loss, they will try to avoid the certainty of a loss by undertaking greater risks. For instance, a gambler who has lost money continuously will keep on betting more or continue to play more rounds to recover the money he’s lost. This proves the risk-seeking nature of individuals when losses are certain.

2. Isolation Effect

The isolation effect is the tendency to focus on the differences between the options and disregard the similarities to simplify the decision-making process. It places a greater weight on the differences because remembering all the details of each individual option places a huge cognitive load on the individuals. Although disregarding the common elements makes comparing alternatives easier, it may lead to inconsistent choices depending on how the alternatives are presented. Along with that, we may disregard some important factors that are crucial in the decision-making process.

3. Loss-Aversion

Loss-Aversion states that the fear of losses is greater than the joy of gains even if the probability of loss is minimal. Therefore, prospect theory says that people believe in minimizing losses rather than maximizing gains. Losses bring about a greater reaction, which means it causes more emotional damage to an individual. For instance, a gambler who won Rs 5000 initially has lost Rs 4000, which will instigate agony although he is still ahead by Rs 1000.

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How Does Prospect Theory Impact Investing?

Investing involves a psychological aspect that can be explained with the help of prospect theory. It tells that the investors make decisions based on perceived gains or losses. In the process, investors end up making irrational choices to avoid the pain of losing money, some of which are as follows.

1. Accumulation of Losing Stocks

Prospect theory revolves around the concept of avoiding losses, which might create a barrier towards the possibility of earning greater gains. In the world of investing, investors often hold onto their positions because they do not like to close at a loss even when alternatives are available. The losses might be quite minimal at present but, there is a risk of higher losses in the future due to deteriorated fundamentals. Selling the stocks at a loss would translate to a personal loss to the investor making them hold onto the losing stocks with the expectation that the prices will recover.

2. Early Profit-booking

If an investor purchases a particular stock and it soon rises in value, then they’ll be ready to book the profits rather than let the stock reach its full potential before selling it. Traders want to avoid the uncertainty of a loss in the future and believe that selling it for a small profit is already a win for them. Hence, they are risk-averse whenever they are faced with a certain gain. By booking an early profit, they lose the chance of earning a higher return had they adopted a buy-and-hold strategy. They avoid the pain of loss by booking a profit early, which might seem profitable in the short run, only to discover numerous lost opportunities in the long run.

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3. Excessive Risk-taking Behavior

Prospect theory says that people seek risks in order to avoid losses. It is common in investing as well. Investors end up taking a lot of unnecessary risks to save their past investments. This means if investors face a loss, they will try to discover ways to mitigate the loss rather than accept it. One strategy investors use is averaging out the prices. For instance, an investor has purchased 100 shares worth Rs 100 each. If the price of the stock declines to Rs 98 per share then, the investor would purchase additional 200 shares of the stock to reduce the average cost. Now, the investor owns 300 shares worth Rs 98.7 each. The investor hopes that the price rises to Rs 99 per share so that the previous losses are recovered. However, if that does not happen and the price further declines, his/her losses get multiplied.

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