An Introduction To Prospect Theory

Throughout your journey as an investor you will likely come to wonder why you make some of the decisions that you do. While you probably have rational for the choices you make, it is not uncommon to be curious about the deeper psychology behind economic decisions. Further, by gaining a better understanding of your decision-making process, regarding finances (often referred to as behavioral finance), you might be more likely to make the most logical decisions more frequently. A method of achieving this is to study some of the different theories that aim to explain the how we, as investors, think about our monetary performance —I.e. gains and losses. One example of these theories is called “Prospect Theory,” let’s further explore it:

Prospect theory is built around the assumption that people value losses and gains differently. Therefore, as humans, we end up making decisions based off our perceived gains instead of our perceived losses. Further, some individuals refer to this as “loss-aversion theory.” Generally, though, the basic concept is that if two choices are presented to an individual, both equal, but one is shown in terms of possible gains and the other in potential losses, the former option will be more attractive — and, thus, the one that is chosen.

For instance, imagine an investor is given a pitch for the same start-up venture by two separate entrepreneurs. The first focuses their pitch around the fact that the start-up has outperformed its direct competitors by an average return of 20% since inception (which was five years prior). Meanwhile, the second entrepreneur shares with the investor that the company has led the industry, on average, since inception (five years ago) despite the fact that it has not been profitable since year two. Although these pitches might both be completely accurate, and regarding the same company, according to prospect theory, the investor is likely to make a deal with entrepreneur number one. This is because the first entrepreneur only focused on the overall returns since inception — which lead the industry — rather than acknowledging that the company has also had losses in recent years.

In addition to understanding the basic principles of prospect theory, it might be beneficial for you to know some of the history behind it. For example, prospect theory is categorized under the greater umbrella of “behavioral economics” which is a sub-group of economics that describes how people make choices where risks are involved and the probability of different outcomes is generally unknown. While the general theory was originally conceived in 1979, it was not further developed until 1992 by Amos Tversky and Danial Kahneman. Today, under prospect theory, the underlying explanation of a person’s behavior is as such: since the possible choices are both independent and singular, the probability of a gain or a loss is assumed as being 50/50 rather than the probability that is really presented. Therefore, the probability of a gain tends to be perceived as greater — as can be seen through the example provided above.

Ultimately, while prospect theory is just one theory that falls under the larger sub-group of “behavioral economics,” studying/understanding it could potentially aid you in future decision making processes. Even the best investors must make tough decisions sometimes (as the right answers are not always clear), however, knowing one’s natural tendencies and biases could possibly be the key to navigating them in the most effective manner possible.