PROSPECT THEORY
• LOSSES HURT MORE THAN GAINS FEEL GOOD (LOSS AVERSION). • PEOPLE TEND TO OVERREACT TO SMALL PROBABILITY EVENTS, BUT UNDERREACT TO LARGE PROBABILITIES. • RISK-AVERSE BEHAVIOR WHEN GAINS HAVE MODERATE PROBABILITIES OR LOSSES HAVE SMALL PROBABILITIES; RISK-SEEKING BEHAVIOR WHEN LOSSES HAVE MODERATE PROBABILITIES OR GAINS HAVE SMALL PROBABILITIES. • PROBABILITY DISTORTION IS THAT PEOPLE GENERALLY DO NOT LOOK AT THE VALUE OF PROBABILITY UNIFORMLY BETWEEN 0 AND 1. LOWER PROBABILITY IS SAID TO BE OVERWEIGHTED (THAT IS A PERSON IS OVER CONCERNED WITH THE OUTCOME OF THE PROBABILITY) WHILE MEDIUM TO HIGH PROBABILITY IS UNDER-WEIGHTED (THAT IS A PERSON IS NOT CONCERNED ENOUGH WITH THE OUTCOME OF THE PROBABILITY)
• ONE INVESTOR WAS PRESENTED WITH THE SAME MUTUAL FUND BY TWO DIFFERENT FINANCIAL ADVISORS. THE FIRST TELLS THE INVESTOR THAT THE MUTUAL FUND HAS HAD AN AVERAGE RETURN OF 7% OVER THE PAST FIVE YEARS. THE SECOND ADVISOR TELLS THE INVESTOR THAT THE MUTUAL FUND HAS SEEN ABOVE-AVERAGE RETURNS IN THE PAST 10 YEARS BUT HAS BEEN DECLINING IN RECENT YEARS. ACCORDING TO PROSPECT THEORY, EVEN THOUGH THE INVESTOR IS PRESENTED WITH THE SAME MUTUAL FUND, HE OR SHE IS MORE LIKELY TO BUY THE MUTUAL FUND FROM THE FIRST ADVISOR, WHO EXPRESSED THE RATE OF RETURN AS AN OVERALL 7% GAIN, RATHER A COMBINATION OF BOTH HIGH RETURNS AND LOSSES. • WE HAVE AN IRRATIONAL TENDENCY TO BE LESS WILLING TO GAMBLE WITH PROFITS THAN WITH LOSSES. THIS MEANS SELLING QUICKLY WHEN WE EARN PROFITS BUT NOT SELLING IF WE ARE RUNNING LOSSES. • PROSPECT THEORY [...] HELPS EXPLAIN HOW LOSS AVERSION, AND AN INABILITY TO IGNORE SUNK COSTS, LEADS PEOPLE TO TAKE ACTIONS THAT ARE NOT IN THEIR BEST INTEREST. THE STING OF LOSING MONEY, FOR EXAMPLE, OFTEN LEADS INVESTORS TO PULL MONEY OUT OF THE STOCK MARKET UNWISELY WHEN PRICES DIP.’
• ‘IN A NUTSHELL, PROSPECT THEORY ASSUMES THAT INVESTORS' UTILITY FUNCTIONS DEPEND ON CHANGES IN THE VALUE OF THEIR PORTFOLIOS RATHER THAN THE VALUE OF THE PORTFOLIO. PUT ANOTHER WAY, UTILITY COMES FROM RETURNS, NOT FROM THE VALUE OF ASSETS.’ • LOSSES “LOOM LARGER” THAN GAINS. FOR INSTANCE, A LOSS OF $500 IS FELT MORE THAN A GAIN OF $500. MOST EMPIRICAL ESTIMATES CONCLUDE THAT LOSSES ARE ABOUT TWICE AS PAINFUL AS GAINS ARE PLEASURABLE. • WHEN GIVEN A CHOICE BETWEEN GETTING $1000 WITH CERTAINTY OR HAVING A 50% CHANCE OF GETTING $2500 THEY MAY WELL CHOOSE THE CERTAIN $1000 IN PREFERENCE TO THE UNCERTAIN CHANCE OF GETTING $2500 EVEN THOUGH THE MATHEMATICAL EXPECTATION OF THE UNCERTAIN OPTION IS $1250. • EVENTS OF SMALL PROBABILITY THAT HAVE NEVER OCCURED BEFORE MAY BE ASSESSED AS HAVING A PROBABILITY OF ZERO IN DECISION-MAKING, BUT THIS IS LEADS TO TRAGEDIES IN WHICH PEOPLE FIND THEY HAVE BEEN PLAYING RUSSIAN ROULETTE WITHOUT EVEN KNOWING THEY ARE DOING SO.
• PEOPLE OFTEN DO NOT INTERPRET RISK RATIONALLY, AT LEAST IN ECONOMIC TERMS. IN PARTICULAR, PROSPECT THEORY SHOWS THAT PEOPLE ARE HIGHLY RISK AVERSE WHEN IT COMES TO POTENTIALLY INCREASING THEIR WEALTH, BUT RISK SEEKING WHEN DEALING WITH POTENTIAL ECONOMIC LOSS. • WE ACT ONE WAY WHEN THE SITUATION IS FRAMED AS LOSS, AND ANOTHER WAY WHEN THE SITUATION IS FRAMED AS LOSS. • WE OVERVALUE PROBABILITY OF RISK WHEN THINKING IN TERMS OF LOSS – RISK SEEKING • WE UNDERVALUE PROBABILITY OF RISK WHEN THINKING IN TERMS OF GAIN – RISK AVERSE • THIS LEADS TO IRRATIONAL DECISIONS • WHEN WE ARE AFRAID OF LOOSING WHAT WE HAVE GAINED, WE BELIEVE THAT RISK IS GREATER THAN IT REALLY IS – TYPE 1 ERROR • WHEN FACED WITH CERTAIN LOSS, WE BELIEVE THE RISK IS LESS THAN IT REALLY IS – TYPE 2 ERROR