Wednesday, May 14, 2008

Prospect Theory

I've been reading about decision-making in the presence of uncertainty. This seems to be a necessary task in my life currently. Prospect Theory is a relatively new way to explain the ways that the classical economic foundations of rationality do not always hold. One of the guys who invented it won a Nobel Prize.

If you prefer A to B and B to C, then you should logically prefer A to C as well. However, Kahneman and Tversky found that people violate that rule all the time. Preferences change depending on how A, B, and C are presented to the chooser.

Prospect Theory says that people tend to be relatively risk-averse when thinking about gains and relatively risk-taking when thinking about losses.

For example, suppose someone offers you a choice between taking a guaranteed $3,000 or instead drawing an amount out of a hat with the following odds: An 80% chance of winning $4,000 or a 20% chance of winning nothing. What would you do?
If you're rational, you should take the risk. .80 * $4,000 = $3200, your mathematical expectation of winning. This is greater than the $3,000 guaranteed.

However, in Kahneman & Tversky's tests, 80% of respondents chose the guaranteed $3,000. They were risk-averse. (Deal or No Deal is an exercise in the same vein).

They then repeated the test, but slightly differently. What if you were offered an 80% chance of losing $4,000 and a 20% chance of losing nothing versus a 100% chance of losing $3,000? What would you do?
If you're rational, you should just take the 100% chance of losing $3,000. Again, your mathematical expected outcome from the gamble is -$3,200, which is worse than -$3,000.

However, 92% of respondents took the gamble. They were suddenly not risk averse, even though the situations were mathematically identical. When we are faced with the prospect of losing money, we'd rather take a slim-odds gamble of losing nothing than just hand over less money than we will probably lose anyway.

They did this in a wide variety of experiments, all showing the same results. People aren't necessarily risk-averse, they are "loss averse." "It is not so much that people hate uncertainty--but rather, they hate losing." People suffer a bigger blow from losing money than by gaining the same amount. Losses hurt more.

They argue that all is not lost, all just cannot be explained by standard theories assuming rationality.
"Human choices are orderly, although not always rational in the traditional sense of the word."

Since the theory came out in 1979, it's garnered huge attention. It helps explain behavior of certain investors in the stock market as well historical decisions by rulers and international politics.

I've been thinking of how the decisions we make in the birthing process can be explained by Prospect Theory. Maybe more on that later.

*All quotations come from Kahneman and Tversky as quoted in Against the Gods, the Remarkable Story of Risk by Peter L. Bernstein. Review on this book to come later.

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