Prospect Theory

The asymmetry between the way we make decisions involving gains and decisions involving losses is one of the most striking findings of Prospect Theory. It is also one of the most useful.

Kahneman and Tversky’s first paper on Prospect Theory, which appeared in 1979, describes an experiment that showed that our choices between negative outcomes are mirror images of our choices between positive outcomes.

For e.g. Kahneman and Tversky proposed the following problem. Imagine that a rare disease is breaking out in some community and is expected to kill 600 people. Two different programs are availabe to deal with the threat. If Program A is adopted, 200 people will be saved; if program B is adopted, there is a 33% probability that everyone will be saved and a 67% probability that no one will be saved.

Which program will you choose? If most of us are risk averse, rational people will prefer Program A’s certainty of saving 200 lives over Program B’s gamble, which has the same mathematical expectancy but involves taking the risk of a 67% chance that everyone will die. In the experiment 72% of the subjects choose the risk averse option Program A.

Now consider the identical problem posed differently. If Program C is adopted, 400 of the 600 people will die, while Program D entails a 33% probability that nobody will die and a 67% probability that 600 people will die. Note that the first of the two choices is now expressed in terms of 400 deaths, while the second offers a 33% chance that no one will die. Kahneman and Tversky report that 78% of their subjects were risk seekers and opted for the gamble. They could not tolerate the prospect of a sure loss of 400 lives.

This behaviour, though understandable, is inconsistent with the assumptions of rational behaviour. The answer to a question should be the same regardless of the setting in which it is is posed. Kahneman and Tversky interpret the evidence that people are not risk averse: they are perfectly willing to choose a gamble when they consider it appropriate. But if they are not risk averse, what are they? “The major driving force is loss aversion“, writes Tversky. It is not so much that people hate uncertainty – but rather they hate losing. Losses will always loom larger than gains. Indeed losses that go unresolved – such as the loss of a child or a large insurance claim that never gets settled – are likely to provoke intense, irrational and abiding risk-aversion.

Tversky offers an interesting speculation on this curious behaviour.

Probably the most significant and pervasive characteristic of the human pleasure machine is that people are much more sensitive to negative than positive stimuli…. Think about how well you feel today, and then try to imagine how much better you could feel. …There are a few things that will make you feel better, but the number of things that would make you feel worse is unbounded.

Kahneman and Tversky use the expression “failure of invariance” to describe inconsistent (not necessarily incorrect) choices when the same problem appears in different frames.

Fascinating stuff. “Against the Gods – The Remarkable story of risk” is an incredible book.

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Posted on December 25, 2003, in Uncategorized. Bookmark the permalink. Leave a comment.

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