What is Prospect Theory? How do users take decisions under risk?

15 Sep 2020  Read 195 Views

Greed and Fear are two of the most common, severe emotions found in any human being. When we are guided by greed or fear in times of uncertainty, making decisions can sometimes be a real challenge. 

For example, Have you ever noticed that most of the people do not invest when markets are going down? Do you know why? Yes, you are right. That's because of their fear. 

And today, markets are going up with all the reasons why people must invest, which is because of greed. Knowing about greed and fear is one thing, but how we make decisions when we are guided by greed or fear in times of uncertainty is the real challenge.

It's the work of two Economists, Daniel Kahneman and Amos Tversky, who received the Nobel Prize in 2002 for their work in behavioral finance. They gave the prospect theory, which is one of the pillars of behavioral finance.

What is prospect theory of behavioral finance?

Prospect theory is one of the pillars of behavioral finance. Prospect theory is based on how we make decisions in terms of uncertainty, how we make decisions when we face risk, and how we behave in our personal and investing decisions when greed and fear catch us. 

Behavioral Finance

Fear only comes when there are losses. So in our feelings towards losses, we suffer from two biases:

  1. Loss Aversion.
  2. Sunk Cost Fallacy.

As far as your feelings towards profits or greed are concerned, then you face:

  1. Status Quo Bias or Decision paralysis.
  2. Endowment Effect.

Loss Aversion 

Have you ever made or heard statements such as: 

"I want to play safe; I would rather be happy with 7% interest than taking the risk in the market"... OR

"I betted on the real estate sector with a 30% exposure. The sector is doing badly, and this has given me a chance to buy low, and now I have 80% exposure. I am sure to recover my losses as stocks are bound to recover".

Most of you would be able to relate to the above statements. However, the thought one might have while making these statements will be different from the other. 

Various types of anomalies are working in these sentences, and it's different for every person. 

To understand this better, let's take an example:

Let us suppose that you invested in two different mutual funds of the same nature. 

In fund 1, your investment worth rs. 4000 is now valued at rs.2000 and in fund two, your investment of rs. 1000 is now also valued at rs.2000. If you need rs.2000 and you need to sell one of your funds, which one would you sell?

Most investors answered it as fund 2. Why? 

Simply because it is excruciating to bear the loss of the first fund but if you look at it rationally, it doesn't matter which fund you sell. It was the frame of the question, which was very important.

If you think like a rational human being, then taking out money from any of the investments won't matter. But you choose to take out the money from the one investment which is profitable because we like the word profit and we don't like the word loss. And this is the reason why casinos run because people don't want to lose; they keep trying to prove themselves.

This is known as "loss aversion." It is one of the components of the prsopsect theory. It has been proved by various researchers of behavioral finance that "the pain of the loss is three times than the pleasure of an equal amount of gain." 

Loss aversion tells that human beings' decision is based on the frame of the reference, that is, the way the question is framed to them. That's why sensitivity to a loss leads people to opt for a particular gain over one that offers a high possibility of a more considerable gain.

Sunk cost fallacy

Every asset has a life, so people keep spending on repairs a lot of times. 

Suppose you have a car which is ten years old; you put in new tires last year, the year before last, you changed the brake linings, this year the gearbox requires an overall change, so you keep on spending on the repairs because you are not asking the question that whether the asset has served its purpose. It should be out, or should you keep on repairing? 

And this is known as getting trapped into the sunk cost fallacy because you fell in love with an asset.

Now under sunk cost fallacy, you try to do two things:

  • Increasing your commitment to justify past actions.
  • Your Ego gets tied to commitment.

Let's take another example.

Suppose you want to reach a particular destination, and there are different types of options available to you. You could go by walking, could also go by bicycle, or could take a car or a taxi, or you can take the bus. 

Suppose you choose to travel by taxi. The taxi was luxurious with a very good interior and was very comfortable too. So do you even then buy the cab? No, because the cab has served its purpose of dropping you from one destination to another. But if you make such decisions, you get trapped by sunk cost fallacy.

Do you remember three idiots? There was a dialogue of R Madhavan, who played Farhan, "I am not fond of engineering, but I go as my father is keen that I become an engineer" this is also a classic example of the sunk cost fallacy. 

Status Quo Bias or Decision Paralysis 

Status quo bias is an emotional bias and is another component of the prospect theory. It states that people do not change their preference for the current state of affairs. People tend to stick towards what they know, given the choice of trying something new or sticking with the tried and tested alternative. We tend to be highly conservative, and that's the case, even as the change can benefit us. This error is called the status quo bias.

Why does the decision paralysis come?

  • The fear of going wrong: Because every time we try to guard our self-esteem, and we fear what might go wrong. And this fear of going wrong is extreme. Generally, in life, we often don't make decisions because we are always worried about questions at every point in time. "What if I go wrong? What if it does not happen?" But we miss out on the most crucial fact that is if you make a decision, there is a 50% chance of going right and a 50% chance of going wrong, but when you don't make a decision, you also lose that 50% chance of going right. That's why in life, you have to decide what to do and never put anything on the backseat and even if you are, just ask yourself, "Are you getting into a decision paralysis?"
  • The possibility of making a loss: The loss aversion inside us is usually extreme. There are two possibilities: one, that you make a loss and second, the fear of making a loss. And when there is a fear of making a loss, your mind gets clouded, you fail to make a decision, and thus, you maintain the status quo.
  • The desire to avoid looking foolish: At times, when we make decisions, and they go wrong, we start feeling that we are stupid. So every time you make a decision, your conviction is going to be challenged, and you have to deal with it.
  • The unwillingness to take risks: Risk is a part of life. Believe it or not, but you have to take risks to keep going. It may be calculated, maybe not.

Endowment effect

Change is a part of life. Things don't remain the same, always. But why is it that are we still resistant to change? Is it because of decision paralysis? Why are we so frightened about a change? Well, the answer to all these questions lies in the endowment effect.

The endowment effect of the prospect theory states that the value of a good increase when it becomes a part of a person's endowment. So whatever we own or want, we value it.

Now let's take an example:

There was a boy named Raju. One day when he went to the market, he was passing by an electronic shop, and he saw a fantastic stereo and went inside the shop. He likes the stereo, and it's a good piece. The shopkeeper asked him to take the stereo with him and said that Raju just had to sign a document and he can keep the stereo for 15 days in his house. Raju was thrilled because his exams had just got over, and he wanted some entertainment at home, so he took the stereo with him. He went home and placed the stereo in his hall. It looked good, and then his mother came and asked where he bought that stereo because she didn't give him the money. So he told his mother about the conversation with the shopkeeper, and that they are not going to buy it, it is just for trial. So they enjoyed the stereo in the house, and his mother also enjoyed listening to songs, and everything was going well.

On the 14th day, Raju told his mother that it was time to return the stereo. So his mother asked him how much the stereo was worth it. He said to her that it was worth 15000 rupees. His mother gave him 15000 rupees, and he goes to the shopkeeper and tells him that he wants to keep the stereo and gives him the money.

Now, do you know why this happened? Why did Raju's mom not want to return the stereo and bought it instead? Well, this is the endowment effect. 

In the above example that we discussed, 15 days was enough for the stereo to become a part of Raju's endowment, and therefore after 15 days, the endowment effect worked, and he went and purchased it. 

Conclusion

"Twenty years from now you will be more disappointed by the things you didn't do than with the ones you did do" - Mark Twain.

And this is one thing that pushes most of us to make decisions because that way, we are going forward; otherwise, we are just decaying. 

Today information flows very fast, and we are on information overload, and that also brings us with the choice overload. And that makes the decision-making process even more difficult.

If you are about to decide on something and you have a lot of information about it, it actually will put you in the decision paralysis mode and will be of no help. And you will ultimately not make a choice. 

So in many circumstances, if you are aware of yourself, it would be more helpful to you to make a decision. It should be understood that we are living in a very fictitious world, and real research is knowing the unknown.

About the Author: Rashmeet Kaur | 15 Post(s)

Rashmeet Kaur is a certified investment advisor. She is aiming to be a financial analyst, and is the one who encourages reading and loves to explore economics and stocks. She loves to discover her own style while writing, and wants to live a creative and adventurous life. 

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