What is the prospect theory? – Chapter 26

In utility theory, the utility of a gain is determined by comparing the utilities of two states of wealth. The utility of receiving an extra € 400 when your wealth is € 2 million is the difference between the utility of € 2.000.400 and the utility of 2 million. If you lose € 400, the disutility is again the difference between the utilities of both states of wealth. It was assumed that the distinction between losses and gains did not matter and was not examined due to the theory-induced blindness.

Kahneman and Amos had focused on differences between gambles with low or high probabilities of winning, until Amos casually mentioned the losses. The risk aversion turned out to be replaced by going for the risk. Consider the following problems:

1. Which do you prefer? Get € 800 for sure or a 90% chance to get € 900.

2. Which do you prefer? Lose € 800 for sure or 90% to lose € 900.

The first problem induces risk aversion, you would go for gaining € 800. In case of the second problem, you will probably go for the gamble (the risk). When all options are bad, people tend to become risk seeking.

The comparison between the problems emphasize the importance of the reference point: the previous state relative to which losses and gains are evaluated. Reference points usually get ignored by people and Bernoulli’s theory lacks them. The prospect theory takes reference points into account. The prospect theory involves three cognitive features (associated with System 1), which play a crucial role in the evaluation of financial outcomes and are common to a lot of automatic processes of emotion, judgment and perception:

• Evaluation is relative to a neutral reference point (‘adaptation level’).

• A principle of diminishing sensitivity applies to the evaluation of changes of wealth and to sensory dimensions.

• Loss aversion.