how the prospect theory works
prospect theory belongs to the behavioral economic subgroup describing how individuals make a choice between probabilistic alternatives where risk is involved and the probability of different outcomes is unknown this theory was formulated in 1979 and further developed in 1992 by amos tversky and daniel kahneman deeming it more psychologically accurate of how decisions are made when compared to the expected utility theory 12the underlying explanation for an individual s behavior under prospect theory is that because the choices are independent and singular the probability of a gain or a loss is reasonably assumed as being 50 50 instead of the probability that is actually presented essentially the probability of a gain is generally perceived as greater tversky and kahneman proposed that losses cause a greater emotional impact on an individual than does an equivalent amount of gain so given choices presented two ways with both offering the same result an individual will pick the option offering perceived gains for example assume that the end result of receiving 25 one option is being given 25 outright the other option is being given 50 and then having to give back 25 the utility of the 25 is exactly the same in both options however individuals are most likely to choose to receive straight cash because a single gain is generally observed as more favorable than initially having more cash and then suffering a loss 3phases of prospect theoryprospect theory asserts that decisions are made through a two stage process instead of considering all available information and possible options which would be impossible humans use a two step process to narrow down the most important information these steps are described as the editing phase and the evaluation phase the editing phase is where people decide which information will be used in the evaluation stage decision makers will use mental shortcuts to assess which information is important and what options are available they also decide which outcomes are most desirable and even rank their priorities the editing phase is important because it can introduce biases that emerge later in the decision process if an individual does not consider certain unlikely outcomes or makes an incorrect assessment of that outcome s probability they may end up making sub optimal decisions later on 4this is the stage where people make their final decisions based on the assessments made in the editing phase people weigh the probability of each outcome and take actions based on the perceived likelihood and desirability of each outcome it is important to note that these decisions are not necessarily based on rational calculations prospect theory posits that people tend to be risk averse when the stakes are high and risk accepting when the stakes are low in other words they tend to make choices that minimize losses rather than maximize expected gains 5characteristics of prospect theoryprospect theory suggests that humans tend to prefer certainties over probabilities for example suppose that you have a choice between being given 50 and a 50 chance of winning 100 most people will take the 50 even though the expected value of the two options is exactly the same prospect theory also asserts that people underestimate or even ignore outcomes with a low probability consequently they also tend to overestimate the probability of likely events resulting in a bias that neglects improbable outcomes this is particularly relevant to investors who must consider the possibility of unforeseen black swan events 36although there is no difference in the actual gains or losses of a certain product the prospect theory says investors will choose the product that offers the most perceived gains 