What Is Prospect Theory? - dummies

By Morris Altman

Part of Behavioral Economics For Dummies Cheat Sheet

Prospect theory, a theory about how people make choices between different options or prospects, is designed to better describe, explain, and predict the choices that the typical person makes, especially in a world of uncertainty. Prospect theory is characterized by the following:

  • Certainty: People have a strong preference for certainty and are willing to sacrifice income to achieve more certainty. For example, if option A is a guaranteed win of $1,000, and option B is an 80 percent chance of winning $1,400 but a 20 percent chance of winning nothing, people tend to prefer option A.

  • Loss aversion: People tend to give losses more weight than gains — they’re loss averse. So, if you gain $100 and lose $80, it may be considered a net loss in terms of satisfaction, even though you came out $20 ahead, because you’ll tend to focus on how much you lost, not on how much you gained.

  • Relative positioning: People tend to be most interested in their relative gains and losses as opposed to their final income and wealth. If your relative position doesn’t improve, you won’t feel any better off, even if your income increases dramatically. In other words, if you get a 10 percent raise and your neighbor gets a 10 percent raise, you won’t feel better off. But if you get a 10 percent raise and your neighbor doesn’t get a raise at all, you’ll feel rich.

  • Small probabilities: People tend to under-react to low-probability events. So, you may completely discount the probability of losing all your wealth if the probability is very small. This tendency can result in people making super-risky choices.