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When making choices that involve risk, most of us tend to shy away from uncertainty. This behaviour is at the heart of prospect theory, which explains the psychology behind our financial decisions.
It’s a principle with significant implications for the financial world, influencing everything from stock market trends to personal investment strategies.
This article will discuss the prospect theory, its features and phases with examples.
What is prospect theory?
Research shows that when faced with choices that include some degree of risk or an unknown outcome, one becomes risk-averse. This tendency is the foundation of prospect theory, a psychological theory with applications to financial markets and behavioural finance.
The decision-making process in situations including risk, unpredictability, and probability is explained by prospect theory. It says people decide what to do based on what they believe they will lose or win.
This idea is also called the loss-aversion theory, which says that if someone has two similar options, one that they can gain from and one that they can lose from, they will choose the one that they can gain from.
How does it work?
Within the behavioural economic subgroup, prospect theory describes how people choose between probabilistic options when there is risk and uncertainty about the likelihood of specific possibilities. Amos Tversky and Daniel Kahneman established this theory in 1992 after it was proposed in 1979.
Prospect theory says that people act the way they do because they think the chances of winning or losing are equal. However, the decisions are separate and unique.
When offered two options that both end in the same outcome, a person will choose the one that they believe will provide them with more emotional fulfilment since losses have a greater impact on them than does an equal amount of gain.
Features of prospect theory with examples
Here are some features of the prospect theory:
Certainty
People tend to lean towards the option they are assured of when choosing between multiple alternatives. In exchange for more assurance, they willingly give up the choice with the higher potential revenue. Take the hypothetical situation where a lottery offers two choices, 1 and 2.
Option 1 guarantees a ₹1,000 win, while option 2 gives you the chance to win ₹5,000, with a 60% chance of gaining and a 40% chance of losing. Even if option 2 gives a higher return, most individuals will select option 1 since it guarantees a victory.
Insignificant chances
Even if the chance of losing all the money is extremely minimal, people still avoid such risks. People prefer greater-risk alternatives with a higher probability because they downplay the minor possibilities.
The use of relative placement
Individuals engage in relative positioning by shifting their attention to the relative gains or losses they could expect, rather than their overall earnings or wealth. Rising incomes won’t make people feel better off if they don’t see an improvement in their relative position.
For example, no one will feel better off if everyone in the workplace gets a 30% raise. But if other individuals don’t receive raises, and one gets a 15% one, they will feel even better off and more successful.
The fear of losing
Rather than considering the benefits of a decision, people are more likely to focus on the costs. For instance, even if they ended up with a net gain of ₹1,000, a person would still dwell on the loss if their earnings were ₹2,000 and their losses were ₹1,000. It appears that people care more about losing than winning.
Phases in prospect theory in behavioural finance
According to the theory, there are two stages to the decision-making process:
- The editing phase
The way decision-makers describe the choices available to them or the framing effects is called the editing phase. The impacts describe how a person’s decision is impacted by the language, arrangement, or style in which the options are presented.
The theory moves on to the second part once the choices are set up and ready to be made.
- The evaluation phase
People often act as if they would pick the choice with better utility during the evaluation phase and base their decision on the possible consequences.
Individuals assess each scenario’s probability and make decisions depending on how likely and desirable they perceive each result to be.
Conclusion
It’s crucial to remember that the choices made by prospect theory aren’t always the result of logical calculations. According to prospect theory, individuals are more likely to take a risk when the stakes are high than when they are low.
This means that instead of maximising estimated benefits, they decide to minimise losses. That’s the essence of prospect theory.
FAQs
Prospect theory, developed by Kahneman and Tversky, is applied in the stock market to understand how investors make decisions under risk and uncertainty. It suggests that investors value gains and losses differently, leading to decisions that deviate from the expected utility theory. In the Indian stock market, this can explain why investors might prefer investments with lower returns but higher certainty, or why they might hold onto losing stocks due to loss aversion.
An example of a stock market anomaly that can be explained by prospect theory is the disposition effect. This refers to the tendency of investors to sell winning investments too early to lock in gains and hold onto losing investments too long in the hope of breaking even. This behaviour is driven by the prospect theory’s principle of loss aversion, where the pain of a loss is felt more strongly than the pleasure of an equivalent gain.
Stock market anomalies are patterns or behaviours in the markets that contradict efficient markets. Anomalies can include irregularities in stock prices, such as the January effect, where stocks historically perform better in January than in other months, or the momentum effect, where stocks that have performed well in the past continue to do so in the short term.
Investor risk attitudes, as described by behavioural finance theories like prospect theory, can explain stock market anomalies by highlighting how psychological biases affect investment decisions. For instance, overconfidence can lead to excessive trading, while herd behaviour can cause asset bubbles. These attitudes can result in pricing inefficiencies and anomalies in the stock market, as investors deviate from rational decision-making.
Behavioural finance is the study of the influence of psychology on the behaviour of investors and financial markets. It challenges the assumption that investors are rational and markets are efficient. Behavioural finance helps explain various market phenomena that traditional financial theories cannot, including stock market anomalies and personal investment strategies.