Prospect Theory: Analysis of Decision under Risk

Question 1

Royal Swedish Academy of Science on Kahneman’s theory

Answer 1

it “integrated insights from psychological research into economic science, especially concerning human judgement and decision making under uncertainty”

Question 2

2 options comparison: the basis

Answer 2

1. £900 now or
2. £1000 with 90% probability
3. lose £900
4. 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

Question 3

Concept of Loss Aversion

Answer 3

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

Question 4

Smith quote on loss aversion

Answer 4

“the chance of gain is by every man more or less over-valued, and the chance of loss is by most men over-valued”

Question 5

How loss averse are we?

Answer 5

• 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

Question 6

Context for loss aversion

Answer 6

• 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

Question 7

Pope & Schweizer Experiment

Answer 7

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

Question 8

Loss aversion in nature

Answer 8

“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)

Question 9

Loss Aversion and the Law

Answer 9

• 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

Question 10

Loss aversion and budgets

Answer 10

“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

Question 11

Loss aversion and negotiations

Answer 11

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

Question 12

Loss aversion and fund managers

Answer 12

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

Question 13

Framing affects our risk appetite

Answer 13

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

Question 14

Why is loss aversion so pervasive?

Answer 14

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

Question 15

Loss aversion and our brain

Answer 15

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

Question 16

Status Quo Bias

Answer 16

an implication of loss aversion is our strong tendency to remain at the status quo

• disadvantages of leaving loom larger than the advantages

Question 17

Experiment by Samuelson & Zeukhauer (2 groups)

Answer 17

1. 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
2. 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”

Question 18

Experiment with donating organs

Answer 18

higher rates of donation when box was already ticked to donate organs

Question 19

Stabilising factor in society

Answer 19

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

Question 20

Relevance to business

Answer 20

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

Question 21

Diminishing sensitivity applies to Prospect Theory

Answer 21

• 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

Question 22

Reference points

Answer 22

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

Question 23

How reference points defy neoclassicism

Answer 23

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

Question 24

Weighting probabilities with emotion

Answer 24

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%)

Question 25

risk averse vs seeking

Answer 25

we are willing to settle for less to avoid the risk of getting nothing

happy to take risks to avoid loss

we overweight the small chance and take the risk if its a gain scenario (lottery ticket)

we overweight the small chance of losing and are risk averse in loss scenario

Question 26

Explaining the demand for insurance

Answer 26

a loss scenario with a low probability (possibility effect) will lead people to buy insurance to avoid a loss

Question 27

Dangerous scenarios in decision making

Answer 27

a loss scenario with high probability (certainty effect)

we are risk seeking to avoid a loss

“people who face very bad options take desperate gambles”

“risk taking of this kind often turns manageable failures into disasters”

• TF&S

Question 28

Asian disease problem

Answer 28

preparing for a disease that will kill 600 people expectedly: 2 programs:

1. 200 people saved
2. 1/3 possibility 600 people saved, 2/3 no-one will be saved

will probably adopt policy A due to its framing

than phrased as:

1. 400 people die
2. 1/3 possibility no one will die (you’d choose this)
   - choices are identical but choices dissimilar
   - decision. makers tend to prefer the sure thing over the gamble when the outcomes are “good” and are risk seeking when outcomes are framed as negative
   - when subjects conformed to the Frame the most active part of there brain was the amygdala which is the emotional arousal part associated with system 1

when they were rational, scans showed enhanced activity in the frontal area associated with rational thinking and system 2

Question 29

Limitations of Prospect Theory 1

Answer 29

1. “house money effect”

if you’ve just won £100 and have to choose between 50% chance to win £30, 50% to lose £130 or no further gain or loss

• people would usually take the risk but PT would suggest being risk averse
• when we are ‘already up’ we are more prepared to take risks
• until our prior winnings are depleted, losses are coded as reductions in gain not losses

can see this sort of behaviour in asset bubbles, and can help to understand risk preferences in the 2008 crisis

• property speculators that’d made money on previous investments saw this as “house money” and given also availability biases and confidence were more prepared to take risks then lost even more

Question 30

Limitations of Prospect Theory 2

Answer 30

if there’s no chance to break even, we won’t take the risk, despite prospect theories predictions that faced with a loss scenario we are more likely to take risks

as even if you win you’re still in a loss scenario

in contrast if you can break even (at higher stakes) you’re more likely to take the gamble

• the difference here is that there are 2 different reference points: where you start off and where you finish
• Prior gains can increase likeliness to take risks
• Prior losses can decrease likeliness to take risks

Question 31

Limitations of Prospect Theory 3

Answer 31

Regret - doesn’t account for it

TF&S: if faced with 90% chance to win £1million or £150,000 with certainty and you lose, you’ll hugely regret it

• will think you were too greedy
• PT(and utility theory) fail to allow for regret and the fact that the experience of an outcome depends on the options you could have adopted but did not

Question 32

Limitations of Prospect Theory 4

Answer 32

Doesn’t consider disappointment

if 90% chance to win £1million

failing to win it is “intensely disappointing…in other words prospect theory cannot deal with disappointment”

• PT in all cases for winning nothing treats the same and doesn’t allow this to change when the prospect of winning is either highly unlikely or when the value of an outcome is extremely disappointing

Question 33

Conclusions of Prospect Theory

Answer 33

“it added to utility theory, notably the reference point and loss aversion, were worth the trouble, they yielded predictions that turned out to be true” - TF&S

• both loss averse and have an aversion to loss
• diminishing sensitivity to loss
• we respond to changes rather than our outright position
• we don’t weight probabilities correctly rather we respond emotionally particularly around the possibility and certainty effect
• framing of a question affects our decisions depending on whether its framed as a gain or loss