WTF is Prospect Theory?

Imagine this: you're at a restaurant, deciding between trying a new dish that sounds potentially delicious but could be a miss, or sticking with your usual favorite. Or think about the last time you agonized over whether to buy that non-refundable ticket for a concert that's months away. These everyday dilemmas have a lot more in common with financial decisions and risk-taking than you might think. That's where Prospect Theory comes in, offering insights into the seemingly illogical decisions we make every day.

When logic takes a backseat

It's easy to assume we all make decisions like perfectly rational robots, always picking the most beneficial option. But the truth is, we're far from it. Our choices are heavily influenced by our emotions, particularly when it comes to wins and losses. Enter Daniel Kahneman and Amos Tversky, the brains behind Prospect Theory in 1979, who revealed that we don't just consider the final outcome. Instead, how we perceive gains and losses plays a huge role, especially the fact that we feel the sting of losses more deeply than the joy of equivalent gains.

Understanding Our Biases

Prospect Theory shines a light on four major biases that skew our decision-making:

Sunk Cost Fallacy:

Ever sat through a bad movie just because you paid for the ticket? That's sunk cost fallacy in action, where we continue a venture based on past investments rather than current benefits.

E.g. You keep a stock plummeting in value because you can't bear the thought of realizing the loss, even though selling might be the wiser financial decision.

Reference Point/Anchor Bias:

When evaluating gains and losses, our 'normal' or initial point (like our current bank balance) heavily influences our perception. If your account dips below what you consider normal, even a small win doesn't bring much joy.

E.g. After getting a bonus last year, you feel disappointed with this year's bonus, even though it's a substantial amount, simply because it's less than before.

Loss Aversion & Probability Weighting:

We go to great lengths to avoid losses, often irrationally favoring this over gaining something of equal value. This bias explains why a 50% chance to win $100 feels less enticing than a sure bet to avoid losing $50.

E.g. You avoid investing in stocks because the potential losses loom larger in your mind than the potential gains, despite the historical trend of long-term growth.

Framing Bias:

How choices are presented can massively sway our decisions. For example, we're more likely to opt for surgery if told it has a 90% survival rate rather than a 10% mortality rate, even though both mean the same thing.

E.g. Marketers use this by advertising a glass as 95% full rather than 5% empty to make products more appealing.

So What?

Prospect Theory has profound implications, touching everything from personal decisions about jobs, relationships, and investments to the strategies used in marketing, economics, and policy-making. Understanding how we react to risks and biases can lead to better decision-making, both personally and professionally.

For instance, recognizing the Sunk Cost Fallacy might make you more willing to let go of investments, projects, or even relationships that are no longer beneficial, instead of sticking with them just because of the resources already invested.

Now what?

Next time you're facing a tough decision, take a moment to consider why you're leaning one way or another. Are you overvaluing a potential loss? Is your decision based on a biased reference point? Understanding these biases, thanks to Prospect Theory, might just lead you to a better choice.

Question

Can you identify a recent decision where these biases might have influenced your choice? How might recognizing these patterns change the way you approach decisions in the future?