What you need to know about prospect theory

What underlies human behavior and thought systems, how these processes work, how they operate, and how they emerge has been the subject of much scientific research, theory, and experimentation. Expectancy Theory, developed by scientists Daniel Kahneman and Amos Tversky in 1979 and awarded the Nobel Prize in 2002, is just one such study. However, what makes this theory interesting is that while it is primarily a theory of behavioral economics and finance, it also contains very interesting explanations for the thought and behavioral processes in people’s daily lives. Here’s what you need to know about prospect theory.

Scientists Daniel Kahneman and Amos Tversky developed Prospect Theory in 1979.

The theory was given to two scientists in 2002 in the field of economic sciences, “for integrating the ideas of psychological research into economics, especially the processes involved in human thinking and decision-making under conditions of uncertainty” He received the Nobel Prize.

What is Prospect Theory?

Prospect theory is basically a theory that attempts to explain how decisions are formed in the face of factors such as risk, uncertainty, loss and gain, and how people make decisions in the face of relevant situations. The theory, founded by Kahneman and Tversky in 1973, emerged as a product of research in behavioral economics and behavioral finance.

In the subsequent period, it continued to develop as an extremely important and interesting theory at the intersection of economics, finance and psychology.

The theory is that people are more interested in not losing anything than in a situation where they can profit by taking risks.

Prospect theory is based on a set of basic assumptions that are said to influence people’s decision-making processes. The first and most important of these is the assumption that explains the behavior of people in situations of loss and gain. According to this assumption, people care more about keeping what they have than about risky acquisitions. Roughly speaking, people prefer smaller, but certain odds of winning, rather than risk with greater prospects of return. Therefore, people avoid taking risks when it comes to winning.

However, according to the theory, human behavior differs from that in the first case in the face of the risks associated with losses in any case. For example, when a person is faced with a situation where the probability of losing 100 TL is 100%, and the probability of losing 200 TL is 50%, he is risk-averse, as opposed to risky situations that involve winning. For this reason, he prefers the second option, given the possibility of incurring large losses. In short, when people are faced with a risk factor, no matter what that risk brings or loses, they choose not to win, but to “avoid losses.”

Prospect theory is widely used to explain the behavior of people in everyday life: “Losing has a greater emotional impact than gaining the same amount”

Because behind the theory is an extremely vivid psychological assumption. Kahneman and Tversky argue against the prospect theory that losses have a greater emotional impact than the same number of gains. That is why people take risks not to gain, but to avoid losses. So when it comes to winning, we turn to the right thing. But when it comes to losing, we are willing to take risks.

The desire to avoid losses described in this theory can lead to extremely dangerous situations. The choices people make when it comes to earthquake risk is a good example.

For example, some people avoid checking their homes in an earthquake zone. Because the house can be a risky structure, so a decision may be made to demolish it. In such a situation, the landlord is faced with two different situations. The first involves the absolute demolition of the house, that is, a 100% loss.

Secondly, the risk that the house will be destroyed by an earthquake in the indefinite future. According to uncertainty theory, people are more likely to risk losing their life or family at an uncertain date in the future than they are to lose their home for sure.

There are important criteria that influence people’s behavior in the face of risky situations of loss or gain: cultural norms, individual preferences, current conditions…

Kahneman and Tversky argue that there is an imaginary or real starting point that influences people’s profit and loss decisions. This starting point is called the “reference point” in uncertainty theory. There are several factors that influence this benchmark, the two scientists say. Kahneman and Tversky evaluate these factors as past experience, current conditions, cultural norms, and individual preferences.

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