Did you know that most of us are really bad at evaluating risks and returns? Most people want to believe we can assess our gains and losses logically, and make rational decisions. But the truth is, we don’t. In this article, we’re going to zoom in on the Prospect Theory, which describes how we choose between risky alternatives when we know the probabilities of the outcomes. In such cases, people tend to make decisions based on the potential value of gains and losses, rather than the outcome itself.
This theory was developed by Daniel Kahneman, the winner of the 2002 Nobel Memorial Prize in Economics. In his book Thinking, Fast and Slow he explains how our brains work, and breaks down how our daily choices are influenced by a wide range of mental biases, shortcuts or heuristics–most of which we aren’t even aware of.
Let’s take a closer look now at the Fourfold Pattern of Preferences and how the Prospect Theory works.
The Prospect Theory and Fourfold Pattern of Preferences
There are 2 mental effects at play: the “Certainty Effect” and the “Probability Effect”.
People are generally risk-averse when they have a high chance of getting a desired outcome.
• In Quadrant 1 (high probability, big gains), people will accept a less-than-expected value of the gamble to lock in a big gain. After all, isn’t it better to have “something” rather than “nothing”? For example, someone may accept a $910,000 settlement rather than go for a lawsuit with a 95% chance of winning $1 million (i.e. they end up accepting $40,000 less than the expected gamble value).
• In Quadrant 4 (low probability, big loss), people are willing to pay a premium for the certainty of not losing. They pay more to remove our anxiety and buy a peace of mind, e.g. that’s why we buy insurance.
We tend to give an irrationally high weightage to a desired but improbable outcome:
• In Quadrant 3 (low probability, big gains), people over-invest in a miniscule chance to win, e.g. why we buy lottery tickets. We unconsciously pay a premium for the right to dream.
• In Quadrant 2 (high probability, big losses), people take desperate gambles, often making things worse in exchange for a small hope of avoiding a large loss. This is why people throw in everything they have to treat a terminal illness, or sink in all their business assets in a futile attempt to catch up with competition. The sad thing is, such challenges would have been manageable, but the fear of loss drives people and companies into take gambles that end in disasters.
Implications of the Prospect Theory
Do the scenarios above seem very familiar to you? Well, we see the Prospect Theory at work everywhere; it explains why we tend to pay an undue amount of attention to rare events such as terrorist attacks or asteroids, compared to likely events such as rain or accidents. This is especially so when the rare events are described vividly, frequently and repetitively.
So, what can you do with this knowledge?
1. Become aware of your biases/ tendencies. In the long-term, it’s costly to put too much weightage on improbable outcomes–whether it is to avoid a small risk (with a potentially big cost), or to get a tiny chance at a potentially huge gain. Simply by becoming aware of these choices being made by yourself and others, you can start to ask smarter questions about the possible outcomes, and make more conscious, educated decisions.
2. Use it to manage your emotional impulses about money. In Unshakeable, Tony Robbins shares some powerful insights from financial gurus like Warren Buffett and Alan Greenspan on why we make poor, emotional decisions in the financial markets, and how to overcome it to build your wealth. Some of these ideas are built on the foundations of Prospect Theory.
3. Use it to improve your influence/ marketing effectiveness. The Fourfold framework applies to almost everyone. By combining it with other knowledge of how the human mind works (e.g. concepts like loss aversion), you’ll start to understand why people tend to prefer a “10% chance to Win” over a “90% chance to Lose”, when they are essentially the same thing. By choosing the right frame, you can influence others’ choices (just as you’ll become more guarded to others’ marketing influence).
• Learn more about the Fourfold Pattern of Preferences and other mental heuristics from the book Thinking, Fast and Slow. [Here are the links to: read the free Thinking Fast and Slow summary, get our full book summary, or to purchase the book].
• Extend your understanding of how our brain works and how we develop “intuition” from the book The Power of Intuition [Here are the links to: read The Power of Intuition summary, purchase our full book summary, or to purchase the book].