Prospect theory is a behavioural economic theory that explains how people decide between probabilistic choices involving risk where the probabilities of the alternative outcomes are understood. The theory suggests that people make choices based upon the psychological value of potential losses and gains rather than the final outcome.
People become risk seeking when all options involve a loss and risk averse when presented with a mixed gamble – where both a gain and a loss are possible.
The theory was developed by psychologists Amos Tversky and Daniel Kahneman. Prospect theory identified three key cognitive features that influence the perception of financial outcomes which are also common factors in general perception, judgement and emotion. These are:
Reference point – We evaluate losses and gains relative to a neutral reference point which is sometimes referred to as an “adaption level”. The status quo is often the reference point, but it can be an expected outcome or what you feel you are entitled to. Outcomes that are above the reference point are classed as gains, whilst any outcomes that are below the reference point are perceived as a loss.
Diminishing sensitivity – People become less sensitive to changes in wealth as the value of the amounts considered rise. This means the subjective difference between £950 and £1,000 is much smaller than the difference between £50 and £100.
Loss aversion – People dislike making a loss more than they do winning. This means that a loss can be perceived to be between 1.5 and 2.5 times the value a gain of an identical size. Loss aversion is probably an evolutionary trait because animals that see threats as more important than opportunities have a greater chance to survive and reproduce.
These three cognitive features of prospect theory are illustrated here in this chart. We can see the psychological value of gains and losses with a neutral reference point (the vertical axis) dividing the chart from left to right. The S-shape function shows the diminishing returns for both losses and gains. However, the two curves of the S are not symmetrical as the slope of the function changes markedly at the reference point. This represents how the response to losses is much stronger than it is to gains.
Professional risk takers such as fund managers and professional poker players are more tolerant of losses because they have learned not to react emotionally to losses. This means that such people are much less loss averse. Indeed, research among financial professionals by Abdellaoui, leichrodt and Kammoun found they show risk seeking behaviour and take very little notice of losses. They were more willing to take a risky gamble and largely ignored losses.
Blind Spots of Prospect Theory:
Although prospect theory certainly explains human behaviour more accurately than utility theory, it does, like any model of behaviour, suffer from a number of blind spots.
It does not allow for the disappointment we feel when winning nothing due to an unusual event (i.e. there is small probability of not making a gain). This is because it does not allow for the value of an outcome to change when it has a very low probability. We would perceive this as bad luck if the chance of not winning anything is very low and would see it as a loss.
Neither can prospect theory allow for the regret we feel when we select a gamble due to greed and then lose out on both potential gains due to the option we selected. We experience regret when an outcome depends on a choice we could have made, but didn’t take.
Prospect theory demonstrates the power of guarantees and money-back offers to tap into our risk-averse nature when faced with the possibility of gains and losses (i.e. making a bad decision). Loss aversion also provides a strong driver of brand loyalty and can be used by companies to frame offers as a potential loss to maximise the perceived psychological value of offers.
The nature of the loss/gain function also provides brands with the opportunity to break up offers into a series of gains to maximise perceived value (see Hedonic Framing). However, where losses are inevitable people are more willing to seek out risky choices as diminishing sensitivity to losses impacts on behaviour. This means that unlike with gains, it is better to combine losses into a single loss (e.g. price + extras) than segregate small losses.
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