Life lessons from Prospect Theory

Imagine that you are walking down a road and you suddenly find a 5$ bill. With a satisfied feeling you put the bill inside your pocket and keep walking. Suddenly a hooded figure comes out of no where and mugs that 5$ bill from you. You end up feeling a little unhappy. In fact you are more unhappy than before you found the bill.

This particular phenomenon(losses are experienced more intensely than gains) is one aspect of what is called ‘Prospect theory’ which was developed by Daniel Kahneman and Amos Tversky in 1979 to explain deviations from rational behaviour.

Two particular aspects of prospect theory seem to have very interesting life applications.

1.Giving too much importance to extreme events
Lets say you have two choices

1. Take 10$
2. Take a lottery ticket which would pay 10000$ to the winner among 1000 people who have a ticket each.

Even though we expect to gain 10 dollars in both scenarios.Most people would end up taking Option 2 . In fact they would take option 2 even if the lottery payout were lower.

Why does this happen ?.The mind tends to overweight the chance that these extreme events happen when we take a decision. Therefore when you take the decision you act as if you have more than a 1 in 1000 chance of winning the lottery.The popularity of the powerball is a classic example of this sort of thinking. You have a greater chance of killing someone or being killed yourself when driving 2 miles to get a powerball ticket than of winning the actual powerball

The life applications are pretty interesting.Usually before we start off any venture we tend to focus too much on what would happen if it became wildly successful or became a spectacular failure. Dont get me wrong it is a very good idea to think about a wide range of scenarios. Problems arise however when we place excessive importance on the extremes.For example placing a higher than necessary emphasis on the chance of total failure leads to paralysis and inaction.Not somewhere we want to be ..

2.Loving risk while losing and hating risk while winning

A casino is one of the most fascinating places to observe human behaviour.

One of the most curious things that you notice is the sort of ‘recklessness’ that takes over when some people lose.Everytime a player loses he keeps increasing his bets even more saying that he or she is going to win the next round.

On the other end of the spectrum is the ‘cautiouness’ which people adopt when they are on a winning streak. They somehow feel guilty that they have won a lot and feel that a loss is ‘overdue’. Hence they cut their bets or
stop playing altogether.

While this sort of behaviour does not make any difference in games such as roulette where each spin is independent of the other, it can be immensely counterproductive in games where the advantage keeps varying such as blackjack. Ironically by being cautious when you are winning you actually bet less when you have the most chance of winning.

The life lessons on this one are pretty popular(“Make hay while the sun shines?”).Lets say you start a business and it starts to turn a decent profit. This means that you are doing something right.Now is not the time to be excessively cautious. The advantage is with you therefore go out and start or atleast think of expanding. If not there are enough ‘second movers’ waiting to take advantage.

On the flip side , do not simply prolong your agony with losses in business in the vain hope that it will turn around some day. Usually entrepreneurs take 3 to 4 businesses before they get it right so its alright to quickly cut your losses and move on

Going all out when you have the advantage is something which can make a tremendous difference in all aspects of life.For example you may be at the local watering hole one friday night and really hit it off with a girl/guy. Now is not the time to go chicken and bail with a vague “Will call some time later” .On the flipside there may be times when “You are up all night and you have not got lucky”.The bar tender announcing ‘Last Call’ is not the time to get crazy and do all sorts of antics (that you may regret later). It may be better to call it a night and retire.

So what is the point ?

While most of what is said here is not rocket science, just understanding that these biases are at play will help us take much better decisions.Understanding the background of why these biases occur also helps a lot with reinforcement