It is extremely common for all modern individuals to participate in trade or bartering agreements. This trade may involve the exchange of currency as well as a swap of other material goods. Really, anytime we engage in a transaction, we encounter prospect theory, a concept that derives from cognitive psychology which outlines how people decide between two options. Although prospect theory is intuitive, many individuals have never directly considered its facets when making an exchange. Prospect theory is incredibly useful and has numerous applications in many fields, from finance and insurance, to industrial organization and due diligence.
Breaking Down Prospect Theory
Prospect theory is a theory that individuals derive utility from gains or losses, which are measured relative to a reference point. The endowment effect is an element of prospect theory and is a manifestation of loss aversion at a reference point, as determined by ownership.
Loss Aversion
Loss aversion is the concept that losses loom larger than gains. We perceive transaction outcomes, not in terms of wealth, but as gains and losses which are relative to a reference point. The reference point corresponds to the psychological value of the acquisition or loss and the actual amount that is paid or received. We can see in figure 1 that loss aversion is represented by an asymmetrical line around a neutral point (in this case it is the reference point) and losses are perceived as 2 to 3 times as powerful as gains. Whereas a gain of 5 cents corresponds to a psychological value added of approximately 18, a loss of 5 cents in a similar transaction would result in a psychological value loss of 40.
Loss aversion is proposed to be constructed by both psychological ownership, or an attachment to the object, and an affective reaction, an emotional connection with the object. Affective reactions are more or less an individual’s gut feeling about an object and, as this emotional attachment increases, loss aversion increases (especially for negative emotions). With regards to ownership, valuation among sellers increases as the owner has possession for a longer duration. Sellers focus on the object or the experience and buyers focus on the expenditure or the money. Many times, a house will remain on the market because sellers value the home at a higher price than the buyers are willing to pay given their current sentiment toward the home.
Figure 1. A hypothetical value function
Endowment Effect
The endowment effect is the difference between buyer’s valuation of their gains and losses, granted their valuation of any object will increase once they are in possession of it. People are typically reluctant to exchange good A for a similar good B because to them, giving up good A involves a larger loss than they would gain by acquiring good B. This is because they value good A higher now that it is theirs and good B does not provide as much value gained as value lost by giving away good A. There is also a pseudo-endowment effect where individuals attain an emotional attachment, or affective reaction, prior to having ownership and this can result in overpaying. When moving, homeowners can be reluctant because of the attachment to their old home or overeager and overpay because they want to ensure that they are the new owners of their next house.
Bad Investments and Risk
Too often investors sell winning stocks too early for fear of a downturn in stock and resulting loss in money. Cashing out of a stock with the initial gain (say $250,000) is seen by investors as more valuable than holding on to the asset and realizing the same gain after the stock increased to a higher valuation ($400,000) and then decreased back to the initial value ($250,000) because in the second scenario it appears as if the investor lost money on the transaction. These same investors will hold losing stocks too long because they do not want to realize the loss. Ultimately, how long an investor will hold onto one of these stocks is a testament to their tolerance of risk.
There is a way to view prospect theory so that it does not stunt growth. While most managers would select the projects or investments that are likely to succeed, the projects that have the most upside require a higher risk tolerance. Across several projects, there is the possibility of failing on four out of every five. However, successful projects have gains that far surpass the losses of failed projects (if there isn’t an unnecessary holding of depreciating assets). Thus, managers should not be discouraged by a few failed projects and continue to invest because of the potential gains. When proposing projects, managers should place the project in context of success as opposed to framing the negative likelihood of failure. Overall, acknowledge the net position after multiple projects, view projects as portfolios not individual assets, and frame innovation projects in terms of success. Perhaps, a home requires repairs in a few areas. What buyers should consider is not solely the individual repairs, but the overall value of the home after the repairs have been made. Will the investment in the home and all of its amazing features outweigh the cost of a few extra fixes?
The Psychological Effect Prospect Theory has on Investors
Prospect theory, comprised of loss aversion and the endowment effect deals, with the psychological values we place on certain objects and what we stand to gain or lose, and it can be appropriately applied to finance and the real estate market. Investors should focus on the overall realized gain as opposed to individual losses which loom large.