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Getting Emotional about Prospect Theory

Prospect theory (Kahneman & Tversky, 1979) is a descriptive theory that models real-life financial decisions people make when faced with uncertain outcomes. Some of the key insights it offers are that human beings are loss averse – we weight losses higher than equivalent gains. Losses and gains are also evaluated with respect to a reference point. Prospect Theory has been used to explain many interesting deviances from rational, normative behaviour. Why, however, are we averse to loss? It is not enough to just capture that we are, it is important to go one step further and understand why.

One interesting explanation might be that the emotional consequences of the decision/choice are what causes this behavior. With a bad decision, or financial loss, emotions such as regret and disappointment come into play, whereas emotions associated with gains are those of elation and rejoicing. Also, negative emotions are generally stronger than positive emotions. An interesting study (Summers & Duxbury, 2007) manipulated the emotions that came into play in a loss scenario, hence producing inconsistencies in how people behaved in the loss frame, breaking the behaviour pattern that is predicted by Prospect Theory.

Consider the sub-optimal behaviour of people who sell winning stocks and hold onto losing ones. This can be explained by Loss Aversion – people do not want to face losses. However, in this experimental manipulation, changing the emotion that the participant experiences during the decision frame, changes this loss-averse behaviour. The study employed two sets of participants – one set who were given stocks that they had to trade (no responsibility condition as they were given the stocks), and another set that picked the stocks they wanted to trade themselves (responsibility condition- picked stocks themselves). When the stocks were losing, people that were given the stocks experienced disappointment, which is associated with avoidance, andsold their losing stocks. On the other hand, people that picked their own stocks experienced regret when their stocks were losing – which is associated with feelings of trying to correct their mistake if given a second chance. These were the people that tended to hold onto their stocks. Thus, under the same loss scenario, the emotion that is anticipated or experienced dictates behaviour and not just loss or gain.

The context therefore, is all powerful, in the sense that engineering the decision-context, could potentially change the emotions that are experienced, and also the resulting behaviour. Preference Reversals could be architectured by carefully redesigning the problem context. Of-course, a real-world scenario is much more complex when compared to a laboratory setting, which makes the mapping of both the current and the desired context extremely challenging. Architecturing this context while problem solving is therefore one of the first steps that FinalMile undertakes.

Image Source: www.bloomberg.com

#Disappointment #Stocks #context #LossAversion #EmotionsandProspectTheory #Winningstocks #ProspectTheory #ChoiceArchitecture #behaviouraleconomics #Losingstocks #Regret

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