When faced with choices involving risk, humans often behave in ways that contradict traditional economic theory. This contradiction is powerfully illustrated by the work of psychologists Daniel Kahneman and Amos Tversky, who developed Prospect Theory to explain how people make decisions under uncertainty. Their experiments show that while humans generally consider themselves rational decision-makers, emotions and biases frequently lead to choices that deviate from logic, especially when potential gains and losses are on the line.
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Introduction: Life as a Series of Choices
In everyday life, we face countless decisions where there’s a probability that we might gain something or lose something. These situations, called prospects in economics, test our ability to weigh risks and rewards. Kahneman and Tversky’s work demonstrated that when presented with these choices, people consistently exhibit a behaviour known as loss aversion—a psychological tendency to fear losses more than they value equivalent gains. This bias, while adaptive in some cases, can sometimes lead to decision-making that is suboptimal in terms of long-term outcomes.
The Experiment: Risk and Reward
In one of their most famous experiments, Kahneman and Tversky presented participants with two different prospects. First, they were asked to choose between:
- An 80% chance of winning $4,000, or
- A guaranteed $3,000.
Mathematically, the first option is the better choice. The expected value of the first option is 80% of $4,000, which equals $3,200. This is greater than the guaranteed $3,000 from the second option. However, most people in the experiment chose the second option. Why? Because the certainty of a guaranteed win was more appealing than the slightly higher potential gain with risk attached. This behaviour demonstrates risk aversion when it comes to potential gains. People prefer the security of a sure outcome, even if it’s slightly smaller.
Next, the researchers reversed the scenario, presenting a negative prospect where participants had to choose between:
- An 80% chance of losing $4,000, or
- A guaranteed loss of $3,000.
Here, participants should logically choose the second option. The expected value of the first option is a $3,200 loss, which is worse than the guaranteed $3,000 loss. Yet, most people chose the risky option, preferring the 20% chance of avoiding any loss at all, even though the average expected loss was larger. This illustrates risk-seeking behaviour in the face of losses—when we’re confronted with the possibility of losing something, we tend to take more risks in the hopes of avoiding the loss entirely.
Loss Aversion and Human Behaviour
At the heart of this decision-making behaviour is loss aversion. Humans tend to experience the pain of losing more acutely than they enjoy the pleasure of gaining. Losing $1,000 feels far worse than the satisfaction of gaining $1,000, even though the amounts are identical. This fundamental bias helps explain why participants in Kahneman and Tversky’s experiment made choices that seemed illogical from a purely mathematical perspective.
This also leads to what’s known as risk aversion in gains and risk seeking in losses. When people are ahead (like when presented with a guaranteed gain of $3,000), they tend to avoid risk, preferring to lock in what they already have. On the other hand, when they’re behind (like when facing a sure loss of $3,000), they become willing to gamble for the chance of breaking even, even if it means risking more.
The Role of Personal Impact: How the Amount of Money Matters
It’s important to note that the impact of money on decision-making isn’t just about probabilities and expected values—it’s also about how much that amount of money personally affects the decision-maker. For example, a guaranteed $3,000 may represent something tangible, like a holiday, paying off debt, or securing a short-term goal. For many people, the difference between $3,000 and $4,000 may not translate into significantly improved life satisfaction. The additional $1,000 (33.33% more) may not dramatically change their holiday experience, while the risk of walking away with nothing could mean losing the holiday altogether.
Thus, people may prefer the psychological comfort of a guaranteed outcome, even if the probabilistically better option offers a slightly higher reward. The diminishing marginal utility of money plays a role here: the first few thousand dollars may have a substantial impact on one’s well-being, but each additional dollar contributes less to happiness or financial security. In such cases, securing a guaranteed outcome becomes a more rational choice when viewed through the lens of personal utility rather than pure mathematics.
The Disposition Effect: How It Plays Out in the Stock Market
Kahneman and Tversky’s insights extend beyond one-off decisions to explain broader behaviours, such as those observed in the stock market. Terence Odean, a researcher in finance, studied trading patterns from 1987 to 1993 and found that investors exhibit a behaviour called the disposition effect—selling winning stocks too early while holding onto losing stocks for too long.
The pattern aligns with Prospect Theory: investors are risk-averse with winning stocks, preferring to lock in a smaller, certain profit rather than risking further gains. On the other hand, they become risk-seeking with losing stocks, holding onto them in the hope that they’ll bounce back, even though this behaviour often results in larger losses over time. Odean’s research found that the winning stocks investors sold continued to perform better than the losing stocks they held onto, meaning that irrational risk-seeking behaviour cost investors real money in the long run.
The Dangers of Loss-Chasing: Gambling and Beyond
This same tendency to chase losses also appears in gambling, where individuals often make increasingly risky bets to recover small initial losses. Gambling companies exploit this behaviour by offering incentives, such as free bets, that encourage people to keep playing after they’ve lost. Once people start chasing losses, they’re more likely to continue until they’ve lost far more than they originally intended.
The principle is simple: the emotional drive to avoid losses can overpower rational decision-making, leading to escalating risks that result in greater losses. While loss aversion is a natural mechanism meant to help people avoid harm, it can backfire when it pushes individuals to take ill-advised risks in the hopes of recouping losses.
Decision-Making in One-Off Versus Repeatable Scenarios
A critical factor in assessing whether people made the “right” decision in Kahneman and Tversky’s experiments is whether the decision is repeatable or a one-off situation. In repeatable scenarios, where the same decision is made over and over, choosing the option with the higher expected value (e.g., the 80% chance of $4,000) is more likely to lead to a better outcome in the long run. However, in one-off decisions, like those presented in the experiments, people often focus on minimising immediate regret or securing a tangible outcome, such as a holiday or avoiding a loss, rather than thinking about the long-term mathematical odds.
In the context of a single decision, choosing the guaranteed $3,000 might seem like the more rational choice from a psychological and personal impact standpoint, even if it’s not the mathematically optimal one. Similarly, opting for the 80% chance of avoiding a loss could feel more justified when the alternative is facing a certain and painful loss.
In repeated scenarios, however, consistently taking risky options when facing losses could lead to compounding bad outcomes, as shown in stock market behaviour and gambling losses. This underscores the importance of distinguishing between decisions in isolation and those made in patterns over time.
Rationality Is Sometimes Relative, but Consistency Matters
Kahneman and Tversky’s work challenges the traditional economic assumption that people always act to maximise their expected value. Instead, their research reveals that human decision-making is heavily influenced by loss aversion, where the fear of losing weighs more heavily than the pleasure of gaining. This leads to patterns of behaviour such as risk aversion when facing gains and risk seeking when facing losses. While these tendencies can make sense in certain one-off scenarios, they often contradict what would be considered rational decision-making in a purely economic sense.
However, it’s important to clarify that rationality is only sometimes relative. In some situations, such as isolated, high-stakes decisions, personal context and emotions can rightly influence choices. For example, opting for the certainty of $3,000 over an 80% chance of $4,000 might seem irrational mathematically, but it can be entirely rational from a psychological perspective if the guaranteed amount meets a specific personal need, such as paying off a debt or funding an important goal. In such cases, prioritising certainty provides emotional security, which can be more valuable than a marginally higher financial gain.
However, in repeatable or long-term scenarios, like investing or trading, this emotional decision-making can become problematic. For traders and investors, consistency in decision-making is key. The disposition effect, where investors sell winning stocks too soon and hold onto losing ones for too long, is a prime example of how loss aversion can erode wealth over time. By selling winning positions prematurely to lock in small gains, and holding onto losers in the hope of a rebound, investors effectively violate the principles of rational long-term strategy. This behaviour often leads to suboptimal financial outcomes, as shown in Terence Odean’s research, which found that stocks sold by investors continued to outperform those they held onto.
For traders and investors, the key takeaway from Prospect Theory is the importance of recognising these cognitive biases and learning to manage them. In markets, where decisions are often repeatable and cumulative, the emotional pull of loss aversion can lead to poor judgement. By understanding that risk aversion in gains and risk seeking in losses can undermine long-term wealth accumulation, traders can make more rational decisions. For example, when faced with a winning stock, an investor should consider the long-term potential rather than rushing to secure a small profit. Conversely, when holding onto a losing stock, the rational course of action is often to cut losses early, rather than hoping for a rebound that may never materialise.
In practice, traders can develop strategies to overcome these biases. One approach is to set predetermined exit strategies based on technical or fundamental indicators, rather than on emotional responses. This way, decisions to sell or hold are driven by objective criteria rather than short-term emotional impulses. Similarly, adopting a mindset that focuses on long-term outcomes rather than immediate gratification can help avoid the pitfalls of the disposition effect and other biases. By maintaining discipline and a consistent strategy, traders and investors can mitigate the psychological pressures that lead to irrational decisions.
In conclusion, while rationality can be relative in one-off situations, such as choosing between immediate financial security and a higher risk, in repeatable contexts like investing, emotional biases such as loss aversion can be detrimental. The ability to manage these biases, through a disciplined and consistent approach to decision-making, is crucial for long-term success in markets. Understanding when to follow a more emotional decision-making framework and when to stick to strict rationality is essential for achieving both psychological and financial well-being.