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VIEWPOINT: Prospect Theory

Daniel Kahneman (Nobel Prize winner) and Amos Tversky developed a theory known as Prospect Theory which shows that, as individuals, we make decisions based on the value of potential losses and gains rather than the final outcome.

The horizontal x axis measures the value of our gain or loss, whilst the vertical y axis measures how we value that gain or loss.

Looking at the red arrow (shown as ‘A’) on the right-hand side of the graph, it shows the objective value of a certain gain. The blue arrow pointing upwards reflects the subjective value we attach to this gain. The observation to take note of is that the subjective value we place is less than the actual objective gain.

Looking at the other red arrow (measured at the same value, that is ‘A’) on the left-hand side of the graph, it shows the same value, but this time as a loss. The blue arrow pointing downwards is longer than the red arrow, showing that the subjective value we attach to this loss is much larger than the actual loss itself.

If the value of A, be it a gain or a loss, was R100, it shows that we place a larger value on a loss of R100 than on a gain of R100.

Even Tiger Woods suffers from this …

In 2009 Pope and Schweitzer published a paper in which they set out the results of a study measuring the presence of the fundamental bias we now know as loss-aversion in a high-stakes context, focusing on professional golfers’ performance on the PGA Tour. As we know, golfers are awarded for the number of strokes they take during a tournament, yet each hole has a salient reference point known as ‘par’.

A total of 2,5 million putts were analysed using precise laser measurements and it was found that golfers play better when attempting to avoid dropping a shot than when trying to gain one, when they consistently leave their shots short. In relative terms, golfers were equating a ‘bogey’ to a ‘loss’, and a ‘birdie’ to a ‘gain’.

In economic terms, this loss-aversion on the part of professional golfers was measured and found to equate to US$1,2 million in tournament winnings per year.

Perhaps something to think about? When faced with probability decisions, while the potential loss should be borne in mind, it shouldn’t be all that you focus on. Don’t lose sight of the potential gain! ❐

Author: Gizelle Willows CA(SA)