Loss Aversion

Suppose you are interested in buying the stocks of a company and your financial advisor presents information about the returns you get on the stock in two different ways:

OPTION A- “The stocks give you an average return of 11%.”

OPTION B- “The stocks usually give you high returns, but in the recent years, there has been a decline in the returns received on the stock.”

Which way the information presented by your financial advisor will make you more likely to buy the stock? Option A, right? 

This phenomenon is called the Prospect Theory or the Loss Aversion Theory. Prospect theory states that losses and gains are valued differently, and thus individuals make decisions based on perceived gains instead of perceived losses. This theory was formulated by Amos Tversky and Daniel Kahneman. It demonstrates how people actually behave, rather than how they should behave, which many would consider a useful model for predicting behavior.

Prospect Theory suggests that people prefer absolute values over probabilities. For example, if you are given a choice between being given $10, and a 100% chance of winning $10, most people will choose being given $10 even though the expected value of both the choices is exactly the same. Furthermore, the theory states that people tend to look badly upon outcomes with a low probability, and look too favorably upon the probability of likely events. This results in a bias that neglects unlikely events.  

While the theory does stipulate that people make decisions based on perceived gains and losses, it does not comprehensively explain why the psychological pain of loss is much more powerful than the psychological pleasure of gain. Therefore, the theory does not explain how our emotions factor into our decisions, but only claims that they do.

However, understanding the prospect theory can help people overcome biases and make more strategic and rational choices. Instead of thinking in terms of gains or losses, individuals can instead think in terms of the values of the anticipated result, without factoring in the present in their decision.