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Prospect Theory

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Prospect Theory

The above chart describes the famous behavioural finance experts Kahneman and Tversky’s discovery that people are more averse to losing $100 than they are to making $100. They called their findings Prospect Theory.

 

Last week was an interesting week as 2 Ph.D. students from different parts of the world spoke to me independently about doing some research using the PsyQuation platform/community. I am naturally keen for us to collaborate and we got to speaking about some of the theory which is a subject close to my heart.

 

In the early part of last week I listened to an excellent podcast with Nobel laureate Daniel Kahneman during which he mentions that he was forced to abandon a very exciting piece of research, that he was very proud of, because academics could not reproduce the findings he found in similar studies. With this backdrop I feel like saying something controversial that I think has merit.

 

According to the famous prospect theory example I am about to describe, we display irrational behaviour, I want to suggest that I am not so sure its entirely irrational.

 

Gain Framing

Option A: Win $400 for certain.

Option B: Win $1,000 if a fair coin comes up heads, and $0 if tails.

 

Loss Framing:

Option A^ : Lose $600 for certain.

Option B^: Lose $0 if a fair coin comes up heads, and lose $1,000 if tails.

 

A and A^ are equivalent as are B and B^. According to prospect theory, more people choose A and B^. 

 

In plain English they are saying people prefer winning $400 for certain rather than entering a lottery with an even chance of winning $1,000. Yet they will enter a lottery with an even chance of losing $1,000 rather than lose $600 for certain.

 

Here comes Mike’s theory: 

I was thinking about this experiment and I started wondering to myself if the same “irrational” results would be present if this experiment was presented not as one off choices but the subject got to choose 100 times. (I am too lazy to look through the literature to see if people included multiple choices into prospect theory academic literature, I cannot remember). 

 

The point I am making is that I do believe we as humans are prone to make irrational choices when “thinking fast”(1 choice), however as humans we are able to learn and by “thinking slow” (multiple choice) we can disarm some of our inbuilt biases. 

 

What I am trying to say in a very long winded way is that we are not helpless to our biases and in some cases the biases are not as potent as we might think they are. (I can’t believe I just said this, I must be high ?)

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