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What is prospect theory?
Loss aversion is one of the most fundamental cognitive biases—those that occur most frequently and cause us to misjudge situations. As a result, we make poor decisions in our personal lives, careers, financial management, and business.
Two distinguished psychologists, Prof. Daniel Kahneman and Amos Tversky, approached these issues scientifically. They developed prospect theory, for which Prof. Kahneman was awarded the Nobel Prize in Economic Sciences in 2002. Tversky had passed away earlier, which is why only one of them received the honor. This theory challenged the model of rational human judgment and has had a profound impact on economics, psychology, medicine, politics, and marketing.
Evolution has "equipped" most of us with a strong need to avoid risk, as it increased our chances of survival, especially in truly dangerous times. This mechanism is reflected, for example, in the saying: "A bird in the hand is worth two in the bush".
Why do we fear losses more than we hope for gains? Prof. Kahneman describes loss aversionas follows: "When we directly weigh and compare gains and losses, losses loom larger than gains. This asymmetry between the power of positive and negative expectations or experiences has evolutionary roots. Organisms that treat threats as more urgent than opportunities have a better chance of surviving and reproducing."
Furthermore, the reaction to a loss is stronger than the reaction to a gain of the same value.
This principle has a massive impact on our decisions. We are constantly forced to choose whether to take a risk to gain something. Should we quit a job we don't like? Invest our savings in starting a business? End an unsatisfying relationship? Buy stocks, gold coins, or Bitcoin? Take out a loan in local or foreign currency?
There is no clear-cut answer to any of these questions—unless someone has a "crystal ball" and can see the future. Every decision involves risk, but it can also bring rewards.
What determines our appetite for risk?
The option we choose each time depends on many factors, including our personality profile, beliefs, patterns learned at home, our own experiences and those of our loved ones, as well as the messages we receive from our immediate environment and the media. This is how advertising and political propaganda work. You can find more on this topic in the article: Harmful beliefs about finances.
Years of pioneering research by Prof. Kahneman and Tversky showed that: "For most people, the fear of losing $100 is stronger than the hope of gaining $150. A loss feels twice as significant as a potential gain." Our decisions are also influenced by how we categorize a given expense or income. You can read more about this in the article: How does mental accounting affect our spending?
Will you take a risk for a win?
Loss aversion protects against taking risks too often. Of course, there is always a segment of the population with a very high risk tolerance. They accept a potential loss if the gain appears huge and worth betting everything on one card. This is the group that includes the biggest winners, but also many losers.
However, most of us are not prepared to take such big risks. We try to calculate the threats and the chances of winning. Although in many cases such caution actually pays off, it can also lead to a trap.
Clients sometimes come to my coaching sessions who are far too afraid of personal or professional change. They overestimate the potential risk and fail to notice the high probability of improving their situation. For this reason, they stay in toxic relationships, do work that burns them out, or remain too long in companies where they are undervalued or face bullying.
SWOT analysis in risk assessment
Of course, every change involves risk. It may always turn out that a new job is actually even worse than the previous one or that we end up in a harmful relationship. This risk cannot be ruled out. However, that should not be a reason to lead an unhappy life! Excessive fear and catastrophizing are not good advisors.
It is worth thinking through the pros and cons of different options and trying to realistically assess both the possibility of success and failure. A good idea is to use a SWOT analysis, which is a classic method used in the strategic analysis of companies.
It involves listing and analyzing:
- Strengths
- Weaknesses
- Opportunities (potential or existing in the environment)
- Threats.
It is a good idea to discuss this list with someone else, such as a friend, coach, or psychotherapist, because it will broaden our perspective and help us discover what we might have missed.
Finally, I want to emphasize that it is impossible to avoid all risk. Especially since most factors are beyond our control and/or unpredictable. We will also never have access to complete data. We are unable to realistically evaluate all the information within our reach. There is an infinite amount of it, whether we are making business, purchasing, or personal decisions.
We cannot escape change or the need to make difficult decisions. Navigating life effectively requires a blend of realism and a positive outlook toward ourselves, others, and the world.
Bibliography:
- Daniel Kahneman, "Thinking, Fast and Slow."
