The Prospect Theory And All About Assurances And Probability
When given two choices, one leaning towards gaining something and another that averts loss, human beings are prone to choose the latter; irrespective of both those choices having the same outcome.
The prospect theory developed by David Kahneman and Amos Tversky in 1992 attempts to explain human behaviour with regard to decision making. It says that human beings are inherently loss-averse. When asked to choose between earning Rs. 50 or earning Rs. 100 then losing Rs. 50, people would choose the former. Although the end result of both these choices is the same, i.e. earning Rs. 50, people perceive the loss differently. The sorrow of losing something is a lot higher than the joy of gaining something and that is what reflects in consumer decisions.
Another proposition made by this theory is that people are more drawn to assurance over probabilities even when the probability is a better choice. If someone is guaranteed Rs. 50 or has a 50% chance of earning Rs. 100, they will choose the former. Again, the outcome of both these options is the same but, the fact that one is an assurance and the other a mere probability, our perception of the situation becomes skewed.
While this theory works in the financial markets every day, especially in the sale of insurance policies, it is also deeply ingrained in our daily lives.
There is no way for us to know for sure what the outcome of every act is going to be; everything then is essentially a gamble. The choices we make are either an attempt to gain something or to not lose what we already have. Chasing assurance or surety is a safer bet, sometimes even a primary instinct. You’d rather know now how things are going to be, than gamble all you have and stand a chance to lose everything. We’re taught to steer clear of gambling because the probabilities can get very twisted. But it’s not always a bad idea to gamble. That is essentially what the theory points out; look twice, the prospects of a probability, a gamble, might be worth more than what you reckon it to be.
In situations where the outcome is the same and the risk isn’t too high, it makes sense to choose surety over a probability. But the next time you chance upon such a fork in the road consider the probability twice over, it might really be the better bet.