Prospect theory in decision making.

Imagine you are a patient, with your doctor who recently declared you a diagnosis of a cancer. Now it is diagnosed, and you explore options with the doctor. If you were given two options as following,

1. Option A -you will have 80% survival at 5 years if you choose this option.

2. Option B -you will have 20% mortality at 5 years if you choose this option.

Even if you were given no other details, although mathematically two options given are essentially having same outcome, it has shown that we tend to choose the first option only because the second option is framed, in terms of risk than the gain. The reason for this is we as humans tend to be risk aversion (when focused on gains)

Similarly consider following example.

1. 100% chance to earn $500 with 0% risk of loss

2. 100% chance to earn $1000 with 100% risk of losing 500

People tend to choose the first option although both of them are equal outcomes.

The explanation for this kind of behavior is due to Prospect theory, in simple terms, Humans tend to value losses more than gains (B >A in the graph). ($1000 has a less value when it is gained than it is lost, psychologically in our mind)

The following graph simply analyses the main arguments.

What is the importance of knowing this in our daily life?

• Imagine you have lost your wallet on your way to the market. You lost $200. The pain you feel may not be proportional, it is more than you are paid $200 less in your monthly salary. Knowing this will reduce the pain. (similarly gains will initially create more psychological value, you will feel happier if you were given 200 when you have no money, than when you already have 200: A> C)

• Think twice before you blame someone on a small lose, is it an exaggerated response which can have consequences later?

• You may be tricked by someone when they frame things emphasizing the benefits and more than risks, especially when they have similar products. Or they can elaborate more on risks when they want you to avoid.

• When you are making important financial decisions, it is important to analyze all the scenarios of gains and losses. You might need help.

Thank you for reading Prospect theory in decision making.

You may also like to read - Question a missed opportunity to question itself.

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