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Managing Profits And Losses: Psychological Considerations – Prospect theory assumes that losses and gains have different values, so individuals make decisions based on perceived gains rather than perceived losses. Also known as the principle of “no bias”, the main idea is that when two choices are placed in front of a person, both are equal, presenting one in terms of potential profit and the other in terms of the possibility of loss, the first choice will be. choose.
Prospect theory belongs to the category of behavioral economics, describing how people make choices between possible alternatives where risk is associated with different possible outcomes. This theory was formulated in 1979 and developed in 1992 by Amos Tversky and Daniel Kahneman, who consider it to be a more logical approach to decision making compared to the expected utility theory.
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An important explanation of human behavior, under the theory of probability, is that because the choices are independent and independent, the probability of profit or loss is considered as 50/50 instead of the probability presented in reality. Basically, the profit potential is generally considered higher.
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Tversky and Kahneman suggested that a loss has a greater impact on a person than an equal amount of gain, so the given choice presents two ways – with both giving the same result – the person will choose a choice that provides benefits.
For example, assume that the end result of receiving $25. One option is offered $25 directly. Other options are given $50 and then $25 back. The $25 benefit is the same in both options. However, people are more likely to choose to receive straight cash because a single profit is seen as more convenient than earning more money first and then suffering losses.
Prospect theory asserts that decisions are made through two processes. Instead of considering all the available information and possible options (which are not possible) people use a two-step process to summarize the important information. These phases are described as the correction phase and the evaluation phase.
The editing phase is where people decide which information to use in the evaluation stage. Decision makers will use short cuts to determine which information is important, and which options are available. They also decide which outcome they like best, and even put their priorities.
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The reform process is important because it can introduce ideas that come later in the decision-making process. If a person does not consider possible outcomes or makes an incorrect assessment of possible outcomes, they may make better decisions later.
This is the stage where people make their final decisions, based on the evaluations made during the renovation. People weigh the probability of each outcome and take actions based on the expected probability of each outcome.
It is important to note that these decisions are not necessarily based on rational calculations. Prospect theory suggests that people tend to be risk averse when risks are high, and risk accepting when stocks are low. In other words, they tend to make choices that minimize losses rather than maximize expected returns.
Prospect theory suggests that people prefer certain things over probabilities. For example, suppose you have a choice between being given $50, and a 50% chance of winning $100. Most people will take $50, although the expected value of both options is exactly the same.
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Prospect theory also posits that people underestimate (or even ignore) outcomes with low probabilities. Therefore, they also take into account the probability of the occurrence of the events, which creates a bias that ignores the results that are not possible. This is important for investors, who must consider the possibility of unknown black swan events.
Although there is no difference in the actual profit or loss of a product, the theory of probability says that investors will choose the product that offers the best profit.
Understanding the theory of hindsight can help people overcome biases and make informed choices. For example, an investor who is aware of their bias toward high-probability stocks may compensate by giving more consideration to low-probability stocks.
It also helps to reframe possible outcomes in a way that minimizes the impact of misunderstandings. Instead of thinking in terms of profit or loss, you can instead think in terms of the value of the expected outcome, without using the present as a reference point. This can reduce the loss bias.
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According to Tversky and Kahneman, the effect of certainty is shown when people prefer certain outcomes and weightless outcomes that are only possible. The certainty effect leads individuals to avoid risk when there is a definite gain. It also contributes to risk-seeking individuals when one of their options is a sure loss.
The isolation effect occurs when people are presented with two options with the same outcome, but different paths to the outcome. In this case, people may override such information to lighten the cognitive load, and their results will vary depending on how the options are framed.
Consider an investor who is assigned two properties for one mutual fund. The first advisor presented the account to Sam, indicating that it had an average return of 10% for the last three years. Meanwhile, the second advisor tells the investor that the fund has had above average returns over the past ten years, but has declined over the past three years.
The Prospect Theory says that although investors are assigned the same account, they can be bought from the first advisor. That is, the investor is more likely to buy the account from the advisor who discloses the amount of money earned in terms of profit only, while the second advisor presents the account as having a high profit, but and loss.
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Prospect theory says that investors value gains and losses differently. That is, if an investor is presented with an investment option based on the potential profit, and another based on the potential loss, the investor will choose to invest where the potential profit is presented.
It is useful for investors to understand their perspective, where losses cause more emotional impact than comparable gains. Probability theory helps explain how investors make decisions.
Prospect theory is part of the behavioral economics movement. It explains how people make decisions between risky and potentially different outcomes. There is a positive effect shown in probability theory, where people are looking for certain outcomes, weightlessness is the only possible outcome.
Prospect theory was first proposed by Amos Tversky and Daniel Kahneman in 1979, who later developed the concept in 1992. The pair argued that prospect theory is best suited to describe how decisions are made correctly, compared to the theory of expected utility.
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Kahneman and Tversky suggested that losses have a more profound effect than gains. They say, when given a choice presented in two ways – with both giving the same outcome – a person will choose the option that offers the benefit.
Prospect theory states that people will accept an investment when presented with a gain, along with a loss. That is, investors weigh potential gains more than potential losses.
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