Prospect Theory - You Know You're Using It?

Prospect theory is the bedrock of behavioural finance that financial advisers make use of every day. The image below shows how the impact of the noble prize drove this research to global attention. The holistic approach of financial advice today means folks just accept the premises underlying this area. We thought it would be interesting to explore the positive and negative aspects of the theory and leave the conclusions up to you.

Just as a reminder, Prospect theory is a behavioural economic theory that seeks to explain how individuals make decisions under conditions of uncertainty. It was developed by psychologists Daniel Kahneman and Amos Tversky in 1979 as an alternative to the traditional expected utility theory. We think it is best illustrated by the following

In terms of financial advice this is best shown this way:

If we link these concepts to the real world of investments and portfolios then prospect theory is reflected in this way:

So as you can see prospect theory is a critical foundation to a whole branch of modern financial advice.

Pros

Descriptive Precision:

Prospect theory furnishes a more precise depiction of decision-making under uncertainty in contrast to conventional expected utility theory. It recognizes that individuals' decisions are shaped by subjective elements like reference points, aversion to losses, and reduced sensitivity to gains and losses.

Loss Aversion:

Prospect theory emphasizes loss aversion, indicating that individuals perceive losses with more intensity than equivalent gains. This understanding clarifies why people lean towards risk aversion when confronted with potential losses, regardless of the expected value pointing towards an alternative decision.

Framing Effects:

Prospect theory acknowledges framing's influence on decision-making. The presentation or framing of a decision can greatly impact people's choices. By incorporating the framing effect, prospect theory offers a deeper insight into individuals' responses to various decision contexts.

Real-World Applicability:

Prospect theory has found extensive real-world applicability across multiple disciplines, such as economics, finance, psychology, and marketing. Its practical relevance has been convincingly demonstrated through numerous studies examining investment decisions, consumer behaviour, public policy, and other related areas.

Cons

Limited Predictive Power:

Although prospect theory provides valuable insights into human decision-making, it does have certain limitations when it comes to its predictive capabilities. One notable limitation is the theory's lack of precise quantitative predictions, which can pose challenges when applying it to situations that demand accurate numerical outcomes. However, it is important to note that while prospect theory may not offer precise numerical predictions, it still offers a robust framework for understanding and analyzing decision-making processes, providing valuable qualitative insights that can inform decision-making strategies.

Lack of Normative Guidance:

While the theory effectively describes how individuals make decisions, it falls short of providing clear guidelines for optimal decision-making. It does not offer a definitive framework for determining the "correct" or rational choice in a given situation.

Subjectivity and Individual Differences:

Prospect theory recognizes the inherent subjectivity of decision-making, which can vary significantly among individuals. However, this subjectivity poses challenges when attempting to generalize findings or apply the theory universally. The theory acknowledges that people have diverse reference points, risk attitudes, and levels of sensitivity to gains and losses. Consequently, these individual differences can complicate the application and interpretation of prospect theory's principles.

Overemphasis on Loss Aversion:

Critics argue that the overemphasis on loss aversion within prospect theory may overshadow other crucial factors that contribute to decision-making under uncertainty. By giving excessive weight to loss aversion, we may neglect the importance of probability weighting and diminishing sensitivity, which are equally vital in shaping our choices. Therefore, to gain a more comprehensive understanding of decision-making, it is imperative to allocate greater attention to these additional factors alongside loss aversion.

Conclusion

It is always important to remember to not always "drink the Kool-Aide". Having an understanding of the pros and cons of bedrock theories is important.

This always reminds me of Einsteins' views on quantum mechanics; "Quantum mechanics is very impressive, but an inner voice tells me that it is not yet the real thing": Einstein recognized the success of quantum mechanics in explaining various phenomena, but he remained unsatisfied with its foundations. He believed that there must be a more complete theory that could explain the behaviour of particles in a deterministic manner. That said he made some huge contributions in this space. So it's ok to question the foundations of theories and work with them in the hope of making things better. Hence our recent posts about positive psychology.

Our list of pros and cons is not exhaustive but gives you some food for thought. We hope it encourages you to think about the idea that there is a balance between utility theory and behavioural finance that explains a big percentage of the risk/return equation.