The Prospect Theory of Kahneman and Tversky

Like it or not, we are all betting individuals. But what interactions are there between the perceived and actual probabilities of things happening and the choices made for or against them? The likelihood of their occurrence, coupled with the size of the gains or losses from anticipating and acting on them, show that people are not entirely the rational agents that we think they are.

Instead of armchair introspection, careful experimental methods were used to give us these (not so) unexpected results. What is demonstrated is that deciding individuals make asymmetric choices based on their poor understanding of relative likelihoods. All sorts of biases and poor thinking on our part contribute to non-rational evaluations of how we end up choosing between alternatives.

The findings are that the near certainty of events happening is undervalued in our estimation, and the merely possible is overvalued. So those things very likely to occur have a diminished weight in our minds, and those things unlikely but possible have an increased weight. These are called the certainty effect and the possibility effect, respectively.

  • Likely Gain (Fear)
  • Likely Loss (Hope)
  • Maybe Gain (Hope)
  • Maybe Loss (Fear)

This asymmetry in valuation leads fearful individuals to accept early settlements and buy too much insurance, or hopeful individuals to buy lottery tickets and play the casino more often then they should if choosing optimally. What factors contribute to this behavior? Emotions, beliefs, and biases, probably all play a role in these perceived payoffs between dread and excitement.

In some “Dirty Harry” movie, the lead character essentially asks “do you feel lucky, punk?”, to goad another into taking a risk. In the movie “War Games”, the supercomputer more or less temptingly asks, “would you like to play a game?”, to encourage the playing of unwinnable matches. Watch out for those that know how to play the odds of hope and fear to manipulate our prospects and decisions.

Further Reading:

https://theoryofself.com/the-four-fold-pattern-decisions-under-risk-e4e634eefc61

https://en.wikipedia.org/wiki/Prospect_theory

View at Medium.com

Daniel Kahneman / Thinking Fast and Slow

[*11.180]

<>

One thought on “The Prospect Theory of Kahneman and Tversky”

  1. Like this post, as there is an individual at work who loves the casinos, buys lottery tickets and smokes. A little more depth here than my previous write-off of simply calling him a risk taker.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

This site uses Akismet to reduce spam. Learn how your comment data is processed.