Unit – II Introduction to

Behavioural Finance
 Prospect Theory,
 Framing, and
 Mental Accounting
Prospect Theory

Ms.
Bushra
 Prospect Theory

 Prospect theory was originally developed by Daniel Kahneman and Amos

Tversky in 1979.

 Prospect theory assumes that losses and gains are valued differently, therefore
individuals make decisions based on the perceived gains instead of perceived
losses. Prospect theory is also known as ‘loss-aversion theory.’

 The basic concept of this theory is that if two choices are provided to an
individual, both equal, with one presented in terms of potential gains and other
in terms of possible losses, the individual will select the choice with possible
gains.
 Prospect Theory
 Prospect theory describes how individuals make a choice between
probabilistic alternatives where risk is involved and the probability of
different outcomes is unknown.

 For example,

a. Most people will prefer winning $50 with certainty rather than taking
a risky bet in which they can toss a coin and either win $100 or
nothing.

b. The same people when confronted with a 100% chance of losing $50
versus a 50% chance of no loss or $100 loss – they would often
choose the second option.
 Key Observed Behaviour

 Key aspect 1: People sometimes exhibit risk aversion and

sometimes exhibit risk seeking, depending on the nature of the
prospect.

 Key aspect 2: Peoples’ valuation of prospects depends on gains and

losses relative to a reference point. This reference point is usually
the status quo.

 Key aspect 3: People are averse to losses because losses loom

larger than gains.
 Prospect theory explains three biases people
use when making decisions:

 1. Certainty: “This is when people tend to overweight options

that are certain and risk averse for gains.”

 2. Isolation effect: “Refers to people’s tendency to act on

information that stands out and differs from the rest.”

 3. Loss aversion: “When people prefer to avoid losses to

acquire equivalent gains”
 Key features of Prospect Theory

 It searches into the fact as to how individuals evaluate gains and losses.

 The theory explains that the investors’ decisions-making process has two
specific phases.

a. First phase is the ‘editing’ process in which they follow a heuristic which is ‘rule
of thumb’ and rank the available alternatives.

b. The other phase is the ‘evaluation’ phase in which investors use some reference
points to evaluate their gains and losses.

 The theory explores that investors ‘frame’ the outcomes of an investment

activity in a very subjective manner which affects expected utility.
 1. Certainty Effect
 “The certainty effect happens when people overweight outcomes that are
considered certain over outcomes that are merely possible.” We would rather
get an assured, lesser win than taking the chance at winning more.

 Which of the following options would you choose?

 100% chance to win $900.
 90% chance to win $1000 or nothing ($0).
 With option 1, you’re assured to get $900. While with option 2, there’s a 10%
chance you could get $1000 or nothing. Studies confirmed that nearly 80
percent of people will choose option 1. Despite the equal potential gain value
i.e. $900, investors depict aversion to the risks.
 People would rather accept a small but certain reward over a mere
chance at a larger gain.
 2. Isolation Effect
 “When multiple stimuli are presented, the stimulus that differs
from the rest is more likely to be remembered.”

 For example: An item on a list which is a different colour, size or font is

more likely to be remembered than the other normal looking listed items.
 3. Loss Aversion Theory

 Loss aversion is an important concept associated with the prospect theory and is
encapsulated in the expression “losses loom larger than gains”.

 It is thought that the pain of losing is psychologically about twice as powerful as

the pleasure of gaining. People are more willing to take risks to avoid a loss than to
make a gain.

 Loss aversion has been used to explain the endowment* effect and sunk cost
fallacy**, and it may also play a role in the status quo bias.
 *Endowment Effect

 The endowment effect refers to an emotional bias that causes individuals to

value an owned object higher, often irrationally, than its market value.

 The endowment effect describes a circumstance in which an individual places

a higher value on an object that they already own than the value they would
place on that same object if they did not own it.

 Endowment effect can be clearly seen with items that have an emotional or
symbolic significance to the individual.

 Research has identified "ownership" and "loss aversion" as the two main
psychological reasons causing the endowment effect.
 **Sunk Cost Fallacy

 the phenomenon whereby a person is reluctant to abandon a strategy or

course of action because they have invested heavily in it, even when it is
clear that abandonment would be more beneficial.

 "the sunk-cost fallacy creeps into a lot of major financial decisions"

 For Example :- Choosing to finish a boring movie because you

already paid for the ticket is an example of the sunk cost fallacy.
Another example is keeping an incompetent employee on staff rather than
replacing them because the company has already invested tens of
thousands of dollars training them.
 Loss Aversion Theory

 Loss Aversion is a pervasive phenomenon in human decision making under

risk and uncertainty, according to which people are more sensitive to losses
than gains.

 The human tendency to take extreme measures to avoid loss leads to some
behaviour that can inhibit investment success.

 So the human attitude to risk and reward can be very complex and subtle,
which changes over time and in different circumstances.
 Loss Aversion Theory

 The basic principle of loss aversion can explain why penalty frames are sometimes
more effective than reward frames in motivating people and has been applied in
behaviour change strategies.

 Loss aversion derives from our innate motive to prefer avoiding losses rather than
achieving similar gains. Knowing that this bias exists and how it affects our decision
making is our ultimate goal.

 Loss aversion is often seen in financial markets: Some evidences that stock
market investors hold their investment positions with paper losses too long and sell
their investment holding paper gains too early.
 Loss Aversion - Example:

 Investing solely in safe products that have little to no interest and as time passes
inflation reduces/eliminates your purchasing power.

 Not selling a stock that is below the price you paid strictly because you do not want to
take a loss.

 Selling a stock because it is greater than the price you paid just to lock in the profits.

 The unwillingness to sell your house for less money than you paid for it.

 Working harder and accomplishing more in an attempt to achieve a stretch goal.

 Focusing on one investment that has lost money while ignoring the other investments.

 Selling to avoid further losses when the reasoning for the investment says to buy more.
The utility received from a gain is disproportionate to the disultity we receive from a loss. In
other words, losses impact on our happiness far more than an equal gain. Therefore, we tend
to value losses and gains in different ways.
 Framing

 Decision frame is a decision-maker’s view of a problem and the possible outcomes.

 A frame is affected by the presentation, the person’s perception of the question, and
personal characteristics.

 If a person’s decision changes simply because of a change in frame, expected utility

theory is violated because it assumes that people should have consistent choices,
regardless of presentation.

 Even the frame matters when the outcomes are nonmonetary.

 Does Prospect Theory Work With
Nonmonetary Outcomes?

In the following problem, would you choose Program A or Program B?

Problem (Survival frame):

 Imagine that the United States is preparing for the outbreak of an unusual Asian disease, which is
expected to kill 600 people. Two alternative programs to combat the disease have been proposed.
Assume that the exact scientific estimates of the consequences of the programs are as follows:

 If Program A is adopted, 200 people will be saved.

 If Program B is adopted, there is a ⅓ probability that 600 people will be saved, and a ⅔ probability
that no people will be saved.

 Which of the two programs would you favor?

 Does Prospect Theory Work With
Nonmonetary Outcomes?

 72% respondents picked Program A.

 The majority seems to be risk averse.

 Notice what happens when the same problem is framed in a

different way:
 Does Prospect Theory Work With Nonmonetary
Outcomes?

Problem (Mortality frame):

 Imagine that the United States is preparing for the outbreak of an unusual Asian disease, which is
expected to kill 600 people. Two alternative programs to combat the disease have been proposed.
Assume that the exact scientific estimates of the consequences of the programs are as follows:

 If Program C is adopted, 400 people will die.

 If program D is adopted, there is a ⅓ probability that nobody will die, and a ⅔ probability that 600
people will die.

 Which of the two programs do you favor?

 Does Prospect Theory Work With
Nonmonetary Outcomes?

 In this case, 78% of the respondents chose Program D.

 Though the problems are identical, now the majority seems to be risk seeking.

 Kahneman and Tversky report this change in risk attitude for students, faculty,
and physicians alike.

 This clearly illustrates that the frame matters.

 Does Prospect Theory Work With
Nonmonetary Outcomes?
 The results are consistent with prospect theory once we recognize that the two problem
descriptions suggest the use of different reference points: the survival frame starts from
full mortality and moves toward partial survival, while the mortality frame starts from full
survival and moves toward partial mortality.

 Saving lives (survival frame) is a gain, while conceding casualties (mortality frame) is a loss.
Since people are prone to loss aversion, the lost lives in the mortality frame loom larger
than the lives saved in the survival frame.
 Mental Accounting
 Mental accounting, a behavioral economics concept introduced by Nobel Prize-winning
economist Richard Thaler, refers to the different values people place on money.

 Mental accounting often leads people to make irrational investment decisions and behave in
financially counterproductive or detrimental ways, such as funding a low-interest savings
account while carrying large credit card balances.

 To avoid the mental accounting bias, individuals should treat money as completely
interchangeable no matter where they allocate it—whether to a budgeting account for
everyday living expenses, a discretionary spending account, or a wealth-building account like
a savings and investment vehicle.