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Prospect Theory – How risk, uncertainty, and probabilities affects our decision-making

My interest in well-being evolved from my interest in decision making - from raising the question of whether people know what they will want in the future and whether the things that people want for themselves will make them happy.

Daniel Kahneman

Photo credits: Max Pixel

In our everyday life, we take hundreds of decisions, some so small that we don’t notice its impacts and some so large that we take time to think through. While many of the decisions affect us directly and indirectly, no matter how small or large it is we always value it. Because our decisions define the choices we make, why we made it and allows us to constantly compare the benefits and losses we gain from that decision. This daily action is explained by the prospect theory developed by Amos Tversky and Daniel Kahneman in 1979.

According to prospect theory, different people value losses and gains differently and individuals make decisions based on perceived gains rather than perceived losses. It takes into account how people make choices when presented with different options and prospects that predict the risks and stake of uncertainty. Contrasting to expected utility theory, prospect theory assumes people don’t always make choices based on expected utility of the choices. Under uncertain situations, people are either risk-averse or risk-seeking. Risk-averse people make decisions under the assumptions of the perceived gains and risk-seeking people take chances on the domain of losses. The main factors that contribute to prospect theory are:

  • Certainty: it’s human nature to be prepared and predict the certainty of outcomes while we are making decisions. Certainty and prospects even make our decisions easier, as we have information on how much risk we are taking and what’s at stake. For example, if taking part in show A gives a guaranteed $500 and doing a performance in the show gives us 80% of chance to gain $800, most people would prefer just participating in the show. Because the outcome of $500 gain is guaranteed, while in the second choice the probability of winning  $800 is based on a risk and there is 20% chance we win nothing. So certainty influences how we perceive our choices and behaviors towards the decision and outcomes.

 

  • Loss aversion: this is the key phenomenon that defines our behaviors in prospect theory. While circumstances shape people’s attitudes as risk-seeking or being risk-averse, it’s natural for many people to weigh losses more than the gains. For example, if you gain $500 dollars and decides to purchase a well-deserved dinner for $200, even though you have $300 for further expenditures, you will focus on the $200 you lost because losing what you had, mattered more than how much you gained, the satisfaction of dinner and remaining $300.

 

  • Probabilities: the percentage likelihood of gain and losses demonstrates the risk and uncertainty in a decision. Probabilities help frame the alternatives and choices in a format that satisfies our needs and circumstances of the moment. With a high percentage of probability and high uncertainty, people become risk-averse, while with a high percentage of probability and less uncertainty they become risk seeking. For example, a 95% chance of winning $1000. For a risk averse person the fear of disappointment in losing and uncertainty makes him risk averse while a risk-seeking person would value the high chances of winning this compared to a 5% of loss, his certainty of winning is 95%. Hence, he would perceive this gain greater than a possibility of falling into the 5% loss category. The reverse works for low probability percentages and uncertainty. If there is 5% chance of winning $1000 the possibility of perceived gain is so low hence he will become a risk averse.

 

While prospect theory is closely interlinked with loss aversion theory, it’s important to understand the psychology of how risk works. Generally, people who are risk seeking are in the domain of losses (the perceived gain is much higher) and they are willing to take the risk to gain the benefit from that outcome. People who are risk averse are in the domain of gains (the perceived loss is low) and they do not have a large certainty or gain from the outcome. So playing it safe is better to them then challenging the situation and taking the risk to loose it all.

In an uncertain situation, people frame the options based on a reference point (example; the current wealth) to analyze the probability of success by comparing it with perceived risks, calculating the trade-offs and cost-benefit with the best balance of tools we can use (negotiate a better outcome with counterpart, or make a win-win deal together, find other alternatives).

However, the limitations of this theory are its does not take into account some other factors that influence our behaviors besides the risk and uncertainty. Emotions, morality, and ethics play a huge role in determining our attitudes. For example, option A is me buying a $300 watch today with no discount and option B is me buying the same watch with 50% chance that there will be a 25% sale on the product in one weeks time. The logical decision would be me to wait one week and take the chance on discount being my risk-averse self. However, because it’s my anniversary and I need to buy that as a present for my spouse, changes the circumstances. I am emotionally driven by the need to buy it and cares less about the discount because giving an anniversary present on anniversary means more than right, then giving it one week later for me to save $25 or $30. But for some extent, we can assume it is these factors that shape or risk identity in making decisions.

 

Nonetheless, prospect theory is too simplified to explain everything. For example, giving up something we possess makes us feel differently than not getting something we want. Prospect theory doesn’t take into account the sentimental values that might be attached to it. Also, it doesn’t concede the possibility of disappointment and regret one might have, because the neutral reference point that the theory considers lies between “what was” and NOT “what could have been when the stakes were large”. Hence, it is better to explain prospect theory as a complex set of factors which frames possible choices relative to a neutral reference outcome, which then makes the choices and decision appear as a gain or loss.

 

About Fathmath Shifa (22 Articles)
Closet writer

3 Comments on Prospect Theory – How risk, uncertainty, and probabilities affects our decision-making

  1. Theories are interesting but limiting. They provide a reference framework. But it is impossible for a theory to take into account all the subtle nuances that affect life.

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  1. Predictions, Pundits, and the 2016 Election: The “Are You Happy Now?” Edition – The Psy of Life

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