If there’s one behavioral concept I think everyone should know about, it’s the prospect theory. Daniel Kahneman (with Amos) proposed this (and won a Nobel prize in economics for his efforts) – I would highly recommend the book ‘Thinking, Fast and Slow’; the amount of wisdom you would gain per unit ink printed is just huge. It’s a slightly large-ish read, but well worth the time. Do get your hands on it.
In any case, let’s talk about the prospect theory. All the economic theories previously had been built on utility theory – which just compares the utilities of two states of wealth, and does not distinguish difference between gains and losses. Kahneman (and Amos) rightly pointed out that our behavior (which is caused by our risk preferences) changes dramatically depending on if we are talking about gains or losses. It’s much easier to explain through an example:
– If you were to chose between a sure shot $500 or 50% chance to get $1000, which one would you go for?
– If you were to chose between a sure shot loss of $500 or 50% chance to lose $1000 (and 50% chance to lose nothing), which one would you now go for?
If you are like the majority, you would chose the sure $500 in the first case, but will tend to gamble in the second case.
If one expects the utility theory to hold true then – if you chose option 1 in the first case, you should have gone with option 2 in the second one. But in reality, people become risk averse when it comes to gains, but become increasing risk-taking when it comes to losses.
Furthermore, as you accumulate your losses, you keep getting even more risk taking. See the graph above? The losses don’t pinch you as much, as the gains make you happy. In essence:
- People think in terms of potential gains and losses relative to some reference point, not in terms of absolute wealth
- People are much more sensitive to potential losses than to potential gains,
and even more importantly,
- Diminishing sensitivity: People are less sensitive to losses the more loss they accumulate.
The third inference is really dangerous – and the earlier you realize this basic behavioral flaw, the better off you would be making decisions.
Now you know why people fail to get up and leave the betting tables after losing bets after bets in casinos and eventually lose it all, despite considering themselves rational.