Prospect Theory & Loss Aversion

[Studystuff]

HI.

I was hoping someone may be able to clear up my confusion between Prospect Theory and Loss Aversion in Chapter 7.

The notes initially describe prospect theory and and talk about the importance of relative positioning and how individuals are risk averse over gains and risk seeking over losses. It then continues to say how "Prospect Theory is associated with the Key concept of Loss Aversion" & it goes on to define LA as
"a person may be much more sensitive to losses than gains of the same magnitude.

I am trying to figure out what the LA component actually contributes to prospect theory. From doing some research on line it seems to be that Loss aversion only means that the utility curve is steeper in the loss region versus the gains region (i.e it doesnt actually state that people are risk seeking for losses, that is a separate part of prospect theory and relates to the curvature of these functions).

I believe that the notes actually misses out on these points, and there is added confusion caused by the fact the figure on page 5 of chapter & is actually symmetric about the origin and doesnt imply loss aversion.

If any of the tutors could confirm my thinking here or show me where I am going wrong I would really appreciate it

 

[Colin McKee]

Hi, You have obviously done a fair amount of background on this. I will give you my spin on it all. Firstly I disagree that the figure on pg5 does not imply loss aversion. If you focus only on the right side, an investor starting from zero would get a certain amount of utility from a (say) £1,000 gain, but would not get twice that utility from a £2,000 gain. So if someone has a £1,000 gain (and associated utility / pleasure / delight) and they are offered a "double or quits" they will likely turn it down. That is where I see loss aversion coming into this theory.
As you say, prospects theory is bigger than that. It looks at someone faced with a loss. If you have a £1,000 loss, you have a certain negative utility, and associated sadness. If someone offers you a double or quits gamble, you might go for it because the utility from a £2,000 loss is not twice that of a £1,000 loss. So a weighted average of £2,000 loss and £0 loss is better than the utility of a certain £1,000 loss.
I hope this helps. I dont think in reality that prospects theory suggests that people will definitely be risk seeking for losses. But some will, whereas very few are risk seeking with their profits or gains.

 

[Studystuff]

Thanks very much for your reply Colin. Some Points:

From my reading online and of CM2, Loss Aversion is to do with gains vs Losses of the same magnitude. I could be misunderstood but is the first feature you explain above not explaining the "diminishing sensitivity" aspect of Prospect Theory? I thought Loss Aversion is do with the fact if you moved plus and minus say 5 points from the origin on the x axis, the loss of utility from say (-5) would far out weigh the gain in utility from + 5 in wealth? This isnt the case on page 5 as the graph in the losses and gains region are actually the same. I believe this photo more shows Loss Aversion in its true sense.

I think I am likely getting too far into it at this stage so I'm inclined to move on and just agree with the SP5 core reading for now.
Let me know your thoughts

 

[Colin McKee]

I certainly agree that this level of detail is unlikely to be required for SP5. But I think we are actually saying the same thing in different ways. I said a gain of 1000 would be better than a 50/50 outcome of 2000 or 0. So I am saying what you are saying above, but from the start point of +1000 on the x axis. I agree that what you have said above, starting with someone who has nothing on the x axis (and therefore no gain to lose), the chart doesnt show loss aversion as the negative and positive utility appear to be the same. But it seems to be just your starting point. Start the individual with a gain to lose, and the individual is risk averse. Start the individual with a loss to gamble and the individual is risk seeking.

 

[Colin McKee]

I havent seen a version of prospects theory where the graph is extended/amplified on the negative side as you have done above. It has always been symmetrical.

 

[Studystuff]

Thanks for the replies Colin!

Having moved on a bit further in the notes, it acknowledges at the end of page 18 chapter 7 that the utility function should be steeper in the loss region. I think its just the fact that this isnt shown in the the graph confused me. Also I am not sure if the "gain to lose" argument holds up as much in prospect theory as it does in conventional utility theory as the reference point in prospect theory moves to your current wealth situation (I think?). Whereas in conventional utility theory you move along the curve based on your absolute wealth level. Let me know what you think

 

[Colin McKee]

Yes, as you mention, it should indeed by steeper on the negative side than the positive. I will see if our chart drawing skills are up to the challenge and change the graph for the next update.
My mention of "gain to lose" was just a way of describing the original Kahneman and Tversky experiment detailed in the notes.
1. Alternative 1: an 80% chance of winning $4,000 and a 20% chance of winning nothing
2. Alternative 2: a 100% chance of winning $3,000.
Option 2 was the "gain" that someone could "lose" if they take the gamble. It is a way of describing why a concave utility function leads to risk-averse decision making and a convex utility function leads to risk seeking decision making.
Having a steeper negative utility function will affect the decision when a person is faced with either zero, or a 50/50 gamble to win £1000 or lose £1000.