The Prospect Theory

In 1978, the American psychologist Herbert Simon won the Nobel Prize in Economics for his research on decision-making in economic organisations. He demonstrated the inefficiency of the human brain in reasoning processes and the resulting tendency of making satisfactory, but not optimal choices.

That same year, Israeli psychologist Daniel Kahneman (2002 winner of the Nobel Prize in Economics), together with his colleague, Amos Tversky, questioned how we might change our decision-making when we are in risky situations, outlined in the so-called Prospect Theory.

The Prospect Theory is a descriptive theory whose purpose is to explain how and why certain choices differ systematically from those provided by a standard method, or from those based on rational behaviour.

Until then, the theory that was commonly being shared was that of expected utility, that is, a rational choice model used to describe the economic behaviour of subjects, who make choices according to the real probability of making a profit from their decision.

The two psychologists, however, noted that this model did not work in cases where the subject has a risk placed in front of them. Different dilemmas were proposed to research participants who were made to experience systematic transgressions according to the principles of utility expected.

For example, if I ask you to choose between the following options:

• A 90% chance of winning $ 500.00.
• Guaranteed win of $ 450.00.

What would you choose?

People do not consider the actual potential monetary gain derived from probabilistic calculus. The psychologists noticed a regular occurrence called the “certainty effect”: participants, when asked to compare the possibility of receiving a sure profit with the probability of receiving a bigger one, overestimate the gain when it is certain, choosing option B in the majority of cases.

In addition to checking peoples' preferences in the case of gain, the researchers also tested the decision-making involved in the event of a possible loss.

If I now asked you to choose between the following options:

• A 90% chance of losing $ 500.00.
• A definite loss of $ 450.00.

What would you choose in this case?

They noted a different behaviour in the participants, so much so that they called the phenomenon “reflection effect”: most people choose first option in the majority of cases. They prefer running the risk of making a probable significant loss (one that is not certain), rather than accepting the certainty of a smaller loss. The same principle, the overestimation of specific data, favours risk aversion when it comes to earnings, and risk research, when it comes to losses.

This discovery was analysed by the authors who listed the various repercussions of Prospect Theory by applying them to every activity in daily life. People do not rationally reflect on the real probability of an event, instead, they select information based on individual subjective schemes until they determine different choices. Researchers define this behaviour as the “isolation effect.”

For example, people can invest their money in a business, with a chance of losing their entire capital. On the other hand, there is an opportunity to earn a fixed wage or a percentage of earnings. The certainty of income increases the attractiveness of this option whilst not considering the possible alternatives.

There is still much to be said, but I would rather stop here. Otherwise, I would end up going into too much detail and, in the end, this chapter would result unclear and tedious. Prospect Theory attaches great importance to the way in which decision-making is interpreted. It proves that problems are formally the same, but when described in terms of gains and losses, give rise to different decisions.

So, in trading, we can see the “certainty effect” when investors sell winning trades too soon, and the “reflection effect” when they hold losing trades for too long.

To conclude the discussion of the two questions above, there are no right or wrong answers, what matters is that there must be symmetry. If you decide to take a sure earning of € 450, the loss must also be securely at € 450 secure. If instead, you choose the probability of getting € 500, then you can choose to wither the certain loss of € 450 (in this case you would have an excellent aversion to risk), or the probability of a loss of € 500.

When we speak of symmetry, we refer to a propensity for balance.