In the early 1980s, Daniel Kahneman and Amos Tverskey proved in numerous experiments that the reality of decision making differed greatly from the assumptions held by economists. They published their findings in Prospect Theory: An analysis of decision making under risk, which quickly became one of the most cited papers in all of economics.
To understand the importance of their breakthrough, we first need to take a step back and explain a few things. Up until that point, economists were working under a normative model of decision making. A normative model is a prescriptive approach that concerns itself with how people should make optimal decisions. Basically, if everyone was rational, this is how they should act.
In contrast, prospect theory is a descriptive model which concerns itself with how decisions are actually made in practice. Let’s begin by dissecting the main normative model of the time: Utility theory.
You may be familiar with the term “homo economicus.” It was coined by economists to describe the perfectly rational economic man. This “rational man” would make decisions that maximized the present value of his utility subject to a given budget constraint. Utility is simply the level of relative satisfaction received from prospects.
If rational economic man is presented with uncertain prospects, he will compare the expected utility values between them and choose the prospect that maximizes utility. If new information about the future is given to rational economic man, he will update his beliefs in accordance with Bayes Theorem.
Conceptually, this is how people should make decisions. They should attempt to obtain the highest possible economic well-being given a budget constraint and the available information. They should be completely self-interested, display risk aversion, and have a diminishing marginal utility of wealth.
For example, consider the following options:
Option 1: we are given $100 guaranteed
Option 2: we flip a coin, heads we are given $200 and tails we are given nothing
Though both options have the same expected return, rational economic man will prefer the riskless option. All of this assumes that rational economic man has complete information on probabilities and can do all the calculations necessary in his head.
Case Against Utility Theory
It is pretty easy to argue that perfect information, perfect rationality, and perfect self-interest doesn’t accurately describe the way people make decisions. In 1936, Keynes noted that:
No human can be fully informed of all circumstances and maximize his expected utility by determining his complete, reflexive, transitive, and continuous preferences over alternative bundles of consumption goods at all times.
Real people have difficulties prioritizing short-term vs long-term goals and they are not completely self-interested. Societal values often play a role. People are also not entirely risk averse, just look at anyone who buys a lottery ticket.
Unlike utility theory, prospect theory is concerned with how people actually make decisions. Prospect theory considers how prospects, or alternative choices, are viewed based on their framing, how gains and losses are evaluated, and how uncertain outcomes are weighted.
During the framing stage, people use past experiences to set a reference point by which to rate the prospects. Prospects higher than the reference point are considered winners, and prospects below are considered losers. Since the framing stage can take shape in different ways, preference anomalies may arise. The same gamble presented in different ways, can have widely varying acceptance rates. This phenomenon is called the isolation effect.
During the evaluation stage, values are attached to changes in wealth rather than final states in wealth, as was the case in utility theory. Furthermore, the weights applied to outcomes don’t coincide with actual probabilities. People overweight low probability outcomes and underweight high probability outcomes. Experiment’s show that people reject a 50/50 gamble unless they can win at least twice the amount of the possible loss. Consider these two options:
Option 1: 50% chance of winning $150. 50% chance of losing $100.
Option 2: 100% chance of losing $100. Or a gamble with 50% chance of winning $50 and a 50% chance of losing $200.
Very few people take the gamble in option 1. They prefer to guarantee that they keep their $100. For option 2, people prefer the gamble over the guaranteed loss. However, both options have the same net gain of $25 by taking the gamble. The situations only differ in that everything is reduced by $100 in the second option. These findings lead to the main insight of prospect theory: people become risk-seeking when facing a loss and risk-averse when facing a gain. In other words, people are loss averse; not risk averse.
As it relates to investing
Consider one investment presented in two ways. To one person, it is presented as returning 7% per year on average since its inception. This person quickly invests. To another person, it is presented as having mostly up years but last year it was down 30%. This person quickly rejects the investment.
This is how a lot of people see the stock market. After a bear market, people frame their decisions to it and forget the long-term average. This was apparent after the great depression and more recently with the great recession. As investors, we should avoid making decisions based on prospect theory’s framing and evaluation. Utility theory is the goal to strive for even if it isn’t the way most people behave.
We should act according to an expected value framework and calculate the probability of events occurring. We should strive to be the rational economic man. This isn’t an easy endeavor. Even people who study framing for a living can fall victim to it.
Prospect theory revealed that preferences are determined by attitudes toward gains and losses, defined relative to a reference point. Decision makers tend to overweight low probability outcomes and underweight moderate and high probability outcomes. Decision makers tend to feel more pain from a loss than they feel joy from a gain. This explains why people may prefer the lottery (overweight low probability of a large win) to the stock market (underweight high probability of a small win).