Prospect Theory: Analysis of Decision under Risk Flashcards
Royal Swedish Academy of Science on Kahneman’s theory
it “integrated insights from psychological research into economic science, especially concerning human judgement and decision making under uncertainty”
2 options comparison: the basis
- £900 now or
- £1000 with 90% probability
- lose £900
- lose £1000 with 10% chance of losing nothing
shows that there’s asymmetry between the power of positive and negative outcomes
we dislike losing more than we like winning
Concept of Loss Aversion
the fact that a loss hurts more than an equivalent gain gives
“it has become the single most powerful tool in the behavioural economists arsenal” - misbehaving
the fear of losing is driving both our decision processes in those scenarios:
- in the gain scenario the fear of losing the money offered makes us want to take the £900
- we are fearful of losing the £1000 we’re offered so we are risk averse
- in the loss scenario, the fear of losing is driving us to take the gamble
Smith quote on loss aversion
“the chance of gain is by every man more or less over-valued, and the chance of loss is by most men over-valued”
How loss averse are we?
- Heads you win £100
- Tails you lose £150
the loss aversion ratio has been estimated in a number of experiments and is normally between 1.5-2.5
we feel losses more than gains by 1.5-2.5 times
Context for loss aversion
- ratio less severe amongst professional risk takers such as traders
- they are continuously exposed to the scenario and so don’t respond in such an emotional way
Pope & Schweizer Experiment
studied over 2.5 million shots at golf
measured whether golfers faced with a put to get a birdie (gain) did better when faced with a put to avoid a bogey (loss) and why
they putted better for par when faced with a loss than when putting for a birder
Loss aversion in nature
“animals fight harder to prevent losses than to achieve gains”
“when a territory holder is challenged by a rival, the owner almost always wins the contest” - TF&S
- we clutter things as if we throw them away its a loss
When delivering bad news, politician will announce they are cancelling tax cuts (reducing a gain) rather than announcing new taxes (creating a loss)
Loss Aversion and the Law
- In tort law (concerned when someone is suing someone else for damages), judges make the distinction between when someone has incurred losses and a failure to make a gain
- in contract law someone is more likely to be held to the terms if it prevents the other party from incurring a loss rather than in making a gain
Loss aversion and budgets
“economic logic implies that cabdrivers should work many hours on rainy days and treat themselves to some leisure time on mild days”
“drivers who have a fixed daily target will work many more hours when the pickings are slim and go home early when rain-drenched customers are begging to be taken somewhere”
-TF&S
Loss aversion and negotiations
two parties negotiating over a shrinking pie will be trickier than over an expanding one
imagine share A you bought for £5000 and is worth £10000
share B you bought for £15000 and is now worth £10000
you need £10000 which are you more likely to sell?
we have a preference for selling winners “disposition effect”
- loss aversion means we sell winning shares too quickly as we don’t want to lose the gains we make and hold the losing stocks as we don’t want to realise the losses
Loss aversion and fund managers
more likely to take risks to avoid a loss if their funds are trailing behind their benchmark
Many frauds start off with a loss frame”
- Madoff: started off losing a relatively small amount of money on a trade, he tried to cover it up but kept losing
- Adoboli: one of his trade cost $400k and ended up costing $2.3 billion
Framing affects our risk appetite
individuals given a task as a gain frame are much less likely to use insider information and lie than with a loss Frame
“people who are threatened with big losses and have a chance to break even will be unusually willing to take risks” - Misbehaving
Why is loss aversion so pervasive?
its evolutionary to survive
“by saving a few hundredths of a second from the time needed to detect a predator, thus improves the animals odds of living long enough to produce” - TF&S
“threats are privileged above opportunities” - TF&S
Loss aversion and our brain
gains and losses in our brain activate different areas of our brain
findings from studies “provide a neurological basis for the economic phenomenon of loss aversion”
- Wilkinson and Klaes
Status Quo Bias
an implication of loss aversion is our strong tendency to remain at the status quo
- disadvantages of leaving loom larger than the advantages
Experiment by Samuelson & Zeukhauer (2 groups)
- Inherit large sum from great uncle and are choosing whether to invest in a moderate risk company, high risk company, treasury bills or municipality bonds
- Second group similar but a significant portion of it is already invested in a moderate risk company
you are deliberating whether to leave the portfolio intact or to change it by investing in other securities
more likely to keep in tact because of status quo
“adhered to status quo choices more frequently than would be predicted by the canonical model”
Experiment with donating organs
higher rates of donation when box was already ticked to donate organs
Stabilising factor in society
loss aversion and status quo are important stabilising factors in society
loss aversion is the “gravitational force that holds our life together near the reference point”
- TF&S
Relevance to business
Businesses are aware of loss aversion
advertisers try to aggregate losses and segregate gains
“recognises loss aversion giving us just one painful loss against many pleasures” - Ariely
use marketing examples
Diminishing sensitivity applies to Prospect Theory
- we are decreasingly sensitive to changes in gains and losses at larger amounts
difference between 100 and 200 and 900 and 1000
- imagine weak light in dark room and weak light in light room - Kahneman
- reflects diminishing marginal utility of wealth
Reference points
evaluation of whether a scenario is considered a gain or a loss is made relative to a reference point
cab drivers = daily budget
golfers = PAR
wage cuts
imagine an entrepreneur expects to make £1 million profit but only makes £300k - goes into a domain of losses in expectation
- reference point is therefore a state of mind and the point we value gains or losses
basis of prospect theory
“K&T recognised that we had to change from levels of wealth to changes in wealth” - Misbehaving
How reference points defy neoclassicism
neoclassical expected utility focuses on levels of wealth and ignores how you got to a specific point on the curve
Tom has £1 million after losing £4 million
Sarah has £1 million after lottery
expected utility theory would have them on the same point on graph - but they feel different
Weighting probabilities with emotion
if you had a chance to receive £1million the change in chances to win the money of 0-5% and 95-100% would stand out as our emotions become stringer at extreme and we weight probabilities with emotion
- the movement from 0-5% transforms the situation, creating a possibility that didn’t exist previously - illustrates what Kahneman calls the possibility effect
- this possibility results in giving more weight to small probabilities than they deserve, we overweight the possibility of small events happening
- the movement from 95-100% is called the certainty effect
- outcomes that are almost certain are given less weight than their probabilities justify
we overweight possibility of nothing and underweight chance to won (5-13.2% and 95-79.3%)
