Prospect Theory : How we Make Decisions Under Financial Risk

prospect-theroy

Prospect Theory is a very importnant concept in behavioral economics and psychology that helps us to understand how we make decisions, especially under conditions when there is uncertainty and risk. Prospect Theory was proposed by Daniel Kahneman and Amos Tversky in 1979, it challenges traditional economic theories that we use Tradional theory assumez people always make rational decisions. Instead, Prospect Theory highlights how emotions, perceptions, and cognitive biases influence our choices.

Prospect Theory theory is not just for economists or psychologists—it can be used by anyone and can be applied in everyday life, from financial decisions to business strategies and relationships. Let’s look into the key elements of Prospect Theory and explore how to use it in realworld.

Classical economic theories assume that we humans are rational beings and we aim to maximize utility (or satisfaction) when making decisions. These theories are based on the Expected Utility Theory, which calculates potential gains and losses to predict the most logical choice.

However, Kahneman and Tversky found that humans don’t always act rationally. Instead, emotions and biases often play a important role which lead us to make decisions that deviate from logical reasoning. Prospect Theory offers a more realistic and practical framework by focusing on how people perceive gains and losses rather than their final outcomes.

Core Components of Prospect Theory

Prospect Theory consists of several key principles:

Reference Point Matters

Decisions are often made based on a reference point, which serves as a baseline for evaluating outcomes. For instance, if you get salary increase it will feel like a gain only if it’s perceived as better than what you expecting. If it’s below your expectations, it might feel like a loss, even if your salary is technically increased.

Loss Aversion

One of the most famous insights from Prospect Theory is that we dislike losses more than they enjoy equivalent gains. For example, losing Rs.100 feels more painful than the pleasure of gaining Rs.100. This tendency is called loss aversion and significantly impacts decisionmaking, especially in investments and risk management and Trading.

 Diminishing Sensitivity

As the magnitude of gains or losses increases, their emotional impact diminishes. For example, if we win the joy of winning Rs.1,000 is not 10 times greater than winning Rs.100. Similarly, if we lose. losing Rs.10,000 feels devastating, but losing Rs.20,000 doesn’t feel twice as bad.

Risk Seeking in Losses and Risk Averse in Gains

When people face potential gains, they tend to avoid risk. For instance, If we have given a choice between receiving Rs.500 outright or a 50% chance to win Rs.1,000, most of us choose the guaranteed Rs.500. However, when facing losses, we often take risks to avoid a definite loss. For example, we might prefer a 50% chance to lose Rs.1,000 over a sure loss of Rs.500.

 The Prospect Theory Value Function

The value function in Prospect Theory has two key characteristics:

1. Asymmetry Between Gains and Losses: The curve is steeper for losses than for gains, reflecting loss aversion.

2. Reference Dependence: The function is centered around a reference point, which determines whether an outcome is seen as a gain or a loss.

This Sshaped curve explains why people are more sensitive to losses than gains and why their risk tolerance changes based on the context.

 Applications of Prospect Theory

 1. Investments and Financial Decisions

Prospect Theory explains why investors sometimes hold on to losing stocks for too long or sell winning stocks too early. Loss aversion leads them to avoid realizing losses, even when it’s the rational choice that wqe should make. Similarly, the fear of losing a potential profit can drive premature decisions.

 2. Marketing and Consumer Behavior

Many Marketers and shopping malls and Shops like Dmart use insights from Prospect Theory to frame offers and influence our buying behavior. For instance, framing a discount as “saving Rs.50” always works better than saying “spend Rs.100 to get Rs.50 off.” The emphasis on avoiding loss appeals to consumers’ psychology.

 3. Public Policy and Health Campaigns

Governments and organizations use Prospect Theory to design effective campaigns. For example, antismoking ads uses highlight potential losses, such as health risks, and side effects of smoking to motivate behavior change. Similarly, tax incentive given by government are often framed as avoiding penalties rather than gaining rewards.

 4. Negotiations and Business Strategies

We should understand that people value avoiding losses more than gaining equivalent benefits can help in crafting offers and concessions while negotiating. Businesses houses can leverage this knowledge to design loyalty programs or compensation packages for their employees and their customers.

Criticisms and Limitations of Prospect Theory

While Prospect Theory provides us with valuable insights, it has its its limitations:

Simplistic Assumptions: The theory doesn’t know the individual differences, such as personal experience or emotional resilience.

Overemphasis on Loss Aversion: Some people argye that loss aversion is not universal and may vary across cultures or situations and location to location.

Complexity in Application: While the principles are intuitive and worth considering, applying them accurately in realworld scenarios can be challenging.

Practical Tips for Everyday Decision Making

Here’s how you can use Prospect Theory to make better choices:

1. Be Aware of Reference Points: Recognize that your expectations have influence on how you perceive outcomes in any decision. Adjust your reference point if needed.

2. Combat Loss Aversion: Understand that fear of loss can cloud judgment which will stop us to take action. Take a step back and evaluate decisions logically.

3. Embrace Risk Strategically: Don’t let emotions drive your risk taking and trading decisions. Assess whether risks align with your longterm goals.

4. Focus on Big Picture: Diminishing sensitivity means small losses or gains shouldn’t derail your plans. Keep perspective have plans and take decsions according to them.

 Conclusion

Prospect Theory is a powerful tool for understanding human behavior in decision making (specially in trading). By recognizing how biases like loss aversion shapes our choices, we can make more informed decisions in finance, business, and daily life to get more productive results.

While it challenges the idea that we humans are perfectly rational beings, but, it also highlights the complexity of our psychology. As we deal with uncertain situations, embracing these insights can help us to smarter, more confident decisions.

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