What Is Prospect Theory?

Anticipating People's Reactions to Risk and Uncertainty

What is Prospect Theory? - Anticipating People's Reactions to Risk and Uncertainty

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How much pain would you choose to accept for an uncertain gain?

Saul is aware that the receptionist is staring at him hard. Could it be because he's been noisily drumming his fingers for the last 10 minutes? He quickly stops and exhales deeply to calm himself – which earns him another glare.

Saul is a senior executive in a large and long-established packaging firm. The problem is, he's not sure how much longer the description “large” is going to apply, because competition is increasingly tough. So he is about to propose a radical reshaping and re-prioritizing of the business that will involve both cuts and investment.

He's thought long and hard about how to win the board's approval. He's come armed with facts, charts and projections, and he's practiced his presentation until it's perfect. But he's uncertain of one important factor – how much risk are the company directors prepared to live with? Will they see his plan as the best option for growth or too much of a gamble?

In this article, we'll look at Prospect Theory, and how it might help you to predict and prepare for people's reactions to risk and change.

Understanding Prospect Theory

Prospect Theory is a behavioral economics model that was developed by Daniel Kahneman and Amos Tversky. It uses sophisticated math to describe and explain how people decide between alternatives. But, even at a basic level, it can provide a useful insight into how they might react to what they perceive as loss and gain.

In particular, Prospect Theory illustrates some of the apparently illogical or irrational ways that people can make choices. With this in mind, you can frame your negotiations more persuasively and introduce change in a more appealing way.

Of course, we all prefer a gain to a loss. But Kahneman and Tversky proposed that a loss has a greater emotional impact on us than the equivalent gain does. So, we'll more likely try to avoid a loss than go for a gain. This is true even if our options will have the same result!

Let's illustrate this through a very basic example. Say you're offered $100, but are given two ways to get it. One is simply to be handed $100. The other is that you receive $200 first, then you have to give $100 back. The result, of course, is precisely the same, but people will most likely favor just receiving $100. We avoid experiencing the pain of a loss, even though we would gain overall.

We feel even more strongly when uncertainty is involved. For example, if we have the choice of either definitely receiving $3,000 or probably receiving $4,000 but possibly receiving nothing, we're likely go for the first option of definitely getting $3,000. We prefer a guaranteed gain over even a small chance of no gain.

Yet, our attitude to risk is turned on its head when a similar choice is framed around loss rather than gain. If people are offered the choice of either definitely losing $3,000 or probably losing $4,000 but possibly losing nothing, almost everyone will choose the second option. In other words, we're prepared to take the risk of losing more because we might not have to lose anything!

Lastly, and most irrationally, we lose all of our aversion to risk when a potential gain is large enough – even if the chance of getting it is tiny. We demonstrate this when we buy lottery tickets in the hope of winning a fortune, despite knowing that we'll almost certainly be disappointed when the numbers are called.

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Applying Prospect Theory

To see how Prospect Theory might be useful to you in the workplace, let's return to Saul and his board presentation. (Admittedly, this scenario is slightly artificial, but it helps to illustrate the theory in practice.)

Saul's ideas include reducing the company's overheads by streamlining its operations on the ground and creating a much flatter regional management structure. This would involve a distressing restructure for its employees, and would likely disrupt business temporarily.

He is also proposing that the company allocates a large budget over the next five years to researching and developing drone-based delivery and establishing a strategic relationship with a pioneering tech company. In the short term, this investment would exceed the savings that he hopes to make.

Such a new approach would also mean a radical change to the company's culture and brand. People at all levels would have to commit to time-consuming and complex work, and there would likely be a program of training and recruitment to fill skills gaps.

Taken all together, this would be too much pain for board members to accept on its own, especially as Saul is predicting that the company would do no more than break even as a result. But what's the alternative?

Saul explains how raw materials are becoming increasingly expensive to source, and that competitors are attracting customers away from the company by responding to their needs more quickly. He demonstrates how inefficient practices and unreliable IT are damaging both the company's finances and people's morale.

He also presents evidence of the company's increasing loss of reputation in the market and a fall in employee loyalty and retention, as well as what it's costing to maintain the aging real estate. All of these factors are dragging the business down and there's no end in sight.

So, now the board has a choice. One option is to experience certain losses by continuing business as usual. The other option is to possibly experience greater losses in the short term, with a chance of breaking even overall.

Prospect Theory tells us that people will try to avoid a definite loss even if there's a risk of experiencing a greater loss by doing so. And so the board decides to spend on innovation, to open up to collaboration, to rationalize office space, and to develop the workforce needed to drive the business forward.

Be Prepared!

We've said that this is a slightly artificial example – in reality, the board would likely have more options to consider, and Saul's arguments would be more subtle and detailed. But this imaginary scenario does illustrate why you need to understand what motivates someone who you want to influence, so that you can present your case in the most effective way.

And you can apply this principle at a team level, too. In particular, Prospect Theory tells us that a team member's motivation, and therefore how he or she behaves, might be a surprise to us.

What he considers to be a gain or loss might be different from our own perception. So we can miss an easy chance to win him over by telling him how he'll benefit from our proposal, because we haven't noticed that benefit ourselves. And we risk making matters worse by being unaware of what he fears losing, and so failing to protect him from that loss.

For example, you might propose a departmental restructure and new processes that would create several gains, including a simplified workflow and team members having more say in decisions. But your most experienced person may feel so strongly about giving up her seat by the window that she convinces her co-workers to resist change.

Tip:

Use tools such as The Reframing Matrix and Perceptual Positions to look at situations from other people's points of view, and The Change Curve to understand the strength of team members' feelings when they are facing a potential loss.

Key Points

Prospect Theory is a behavioral economics model that can give you an insight into how people's willingness to take risk affects their choices and decisions. It focuses on their perceptions of, and reactions to, gains and losses, and it can help you to predict and explain apparently irrational behavior. This allows you to understand their emotions better and to present a case, to negotiate a deal, or to introduce change more effectively.

Apply This to Your Life

Think about the decisions that you make each day. Ask yourself what the motivation is behind your choices. Could you change your perceptions of risk and, if so, what effect would this new attitude have on your behaviors? For example, the immediate discomfort of getting up early on a cold, dark morning to go for a walk might be a loss that's stopping you enjoying the gains of improved health and self-esteem.