Episode 15
Why We Make Irrational Decisions: A Dive into Prospect Theory
This podcast episode delves into the groundbreaking insights of Prospect Theory, which revolutionizes our understanding of decision-making under risk. The episode explores how our emotions heavily influence our choices, particularly through concepts like the certainty effect and loss aversion. Listeners will learn that humans often prefer guaranteed outcomes over riskier, potentially more rewarding options, highlighting our innate desire for certainty. The discussion also reveals how, when faced with potential loss, people tend to become risk-seeking, contradicting the rational decision-making model previously held. By unpacking these psychological patterns, the episode encourages us to become more aware of our decision-making processes and to recognize the power we have in shaping our choices for better outcomes.
Paper Referenced:
Kahneman, D., & Tversky, A. (1979). Prospect Theory: An Analysis of Decision under Risk. Econometrica, 47(2), 263–291. https://doi.org/10.2307/1914185
Link - https://www.jstor.org/stable/1914185
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Transcript
Hi, all.
Parv:Welcome to this audio project where we decode the science of human behavior with a twist.
Parv:I'm Parv, and this podcast brings to you AI generated conversations that simplify complex hidden patterns that shape our decisions, emotions, and actions.
Parv:A while ago, I started using NotebookLM to help me translate academic research that talked about hidden internal patterns that make us us.
Parv:So let's dive in and uncover the unique algorithm that makes you you.
Speaker B:Welcome back, everyone, to another deep dive.
Speaker B:This time we are going to get into a research paper that could seriously change how you make decisions.
Speaker B:Like, all of them, big or small.
Speaker B:I'm excited for this one.
Speaker C:It really is fascinating stuff.
Speaker C:I mean, we're going way beyond the usual tips and tricks here.
Speaker C:Like the typical financial advice.
Speaker C:We're going to really look at how your brain actually works when it's faced with uncertainty.
Speaker B:Yeah, exactly.
Speaker B:Like, how do we actually make choices when we don't know what's going to happen?
Speaker B:Which is, like, pretty much all the time.
Speaker B:Right.
Speaker B:So the paper we're diving into today is called Prospect Theory, an Analysis of Decision Under Risk.
Speaker C: man and Amos Tversky, back in: Speaker B:Ago, but it's, like, totally revolutionized behavioral economics.
Speaker C:It really did.
Speaker C:Like, before them, the main idea was that people were basically rational.
Speaker B:Oh, yeah, I remember that.
Speaker B:Expected utility theory.
Speaker C:Right, right.
Speaker C:Expected utility.
Speaker C:The.
Speaker C:The idea that we weigh the possible outcomes by how likely they are to happen, and then, boom, we make the logical choice.
Speaker B:But Kahneman and Turiski came along and were like, hold up, not so fast.
Speaker C:Yeah, basically, they were like, no, people are way more influenced by their emotions and, like, how they perceive things than we realize.
Speaker B:So not quite the perfectly rational decision makers we thought we were.
Speaker C:Nope, not even close.
Speaker C:Like, one of the big things they discovered was something called the certainty effect.
Speaker B:Okay, Certainty effect.
Speaker B:Break that down for me.
Speaker C:Sure.
Speaker C:So it means that we, as humans tend to really overvalue outcomes that are certain.
Speaker C:Like, we love knowing for sure what's going to happen.
Speaker B:Okay, that makes sense.
Speaker B:So even if there's an option with, like, a higher potential payoff, we might go for the sure thing, even if it's less.
Speaker C:Exactly.
Speaker C:Like, imagine this.
Speaker C: a choice between a guaranteed: Speaker B:Okay.
Speaker C: e would go for the guaranteed: Speaker B:Right.
Speaker C:It just feels safer.
Speaker B:Yeah, I think most people would probably choose the sure thing in that situation.
Speaker C: % chance of winning: Speaker B:Oh, so both options have risk now.
Speaker C:Exactly.
Speaker C:And what do you think happened?
Speaker B:I'm guessing people went for the higher potential payoff even though the odds were slightly lower.
Speaker C:You got it.
Speaker C:They completely, completely flip their preference.
Speaker B:So just by, like, changing how the choices are presented, it actually changes what we value Totally.
Speaker C:Like, the presence or absence of certainty totally messes with our decision making.
Speaker C:And this is not just about money.
Speaker B:So it applies to other things too.
Speaker B:Like what?
Speaker C:All sorts of choices, like planning a vacation or choosing between job offers.
Speaker C:Anything where there's risk involved.
Speaker B:Wow.
Speaker B:So it's not just about being, like, good with money.
Speaker B:This certainty effect, it's, like, baked into how we make decisions as humans.
Speaker C:It really is.
Speaker C:And that's why I think understanding it can be so powerful.
Speaker C:Because if we know that we're, like, hardwired to overvalue certainty, then we can start to, like, question our choices a bit more, you know?
Speaker B:Yeah.
Speaker B:Like, maybe we're missing out on some awesome opportunities because we're so focused on playing it safe.
Speaker C:Right.
Speaker C:Maybe taking a calculated risk could lead to a better outcome overall.
Speaker B:Okay.
Speaker B:So recognizing this tendency in ourselves could actually open up the door to better options.
Speaker B:That's pretty cool.
Speaker C:It is.
Speaker C:Now let's flip the script a bit and talk about situations where we're facing a potential loss instead of a gain.
Speaker C:Kahneman and Tversky called this the reflection effect.
Speaker B:The reflection effect.
Speaker B:Okay.
Speaker B:This is where things could get really interesting.
Speaker C:It definitely does.
Speaker C:So with the reflection effect, when people are facing a potential loss, they actually become more risk seeking.
Speaker B:So it's like the opposite of the certainty effect.
Speaker B:Instead of wanting to play it safe, we actually want to take bigger gambles when we're afraid of losing something.
Speaker C:Yeah, exactly.
Speaker C:It's like our brains are trying to, like, outrun the loss, even if it means taking on more risk.
Speaker B:But wouldn't it be smarter to, like, play it safe when you're already in a tricky situation?
Speaker B:You know, to try to minimize the damage logically?
Speaker C:Yeah, but our emotions often, like, hijack that logic.
Speaker C:Like, in one of their studies, Kahneman and Tversky gave people this choice.
Speaker C: % chance of losing: Speaker B:So a slightly higher chance of losing more money or a guaranteed loss of a smaller amount.
Speaker C:Right.
Speaker C:What would you choose?
Speaker B:Well, the guaranteed loss of 3,000 seems like the safer bet.
Speaker B:Even Though it sucks to lose any money.
Speaker C:I think most people would think that way.
Speaker C:But guess what?
Speaker C:Most people in the study actually chose the 80% chance of losing 4,000.
Speaker B:Really?
Speaker C:Yeah.
Speaker B:They were willing to risk a bigger loss just to avoid a guaranteed loss.
Speaker C:Yep.
Speaker C:It's called loss aversion.
Speaker C:And it's a powerful force.
Speaker B:Loss aversion.
Speaker B:So we hate losing so much that we'll actually take on more risk to try to avoid it.
Speaker C:Exactly.
Speaker C:It's like that gambler who keeps doubling down after every loss, hoping to win it all back.
Speaker B:We're like that person who keeps pouring money into a failing business because they can't accept that it's time to cut their losses.
Speaker C:Right.
Speaker C:Loss aversion can be pretty dangerous if we let it take over.
Speaker B:So how does this all tie into prospect theory?
Speaker C:Well, it comes down to how our brains see changes.
Speaker C:Like, we don't focus on our total wealth, or like the overall situation.
Speaker C:We focus on the gains and losses relative to where we are right now.
Speaker B:So it's like our starting point matters more than the actual outcome.
Speaker C:Kind of, yeah.
Speaker C:And here's the kicker.
Speaker C:Losses feel way more painful than gains feel good.
Speaker B:Oh, I totally get that.
Speaker B:Like, losing a hundred bucks hurts way more than finding a hundred bucks feels good.
Speaker C:Right?
Speaker C:That's what I'm talking about.
Speaker C:It's called the asymmetry of gains and losses.
Speaker B:Isometry.
Speaker B:Okay, so losing and gaining aren't equal in our brains.
Speaker C:Nope, not at all.
Speaker C:And that's a big part of why we act so differently when we're trying to avoid a loss versus trying to win something.
Speaker B:Okay, that makes sense.
Speaker B:So we're more risk averse when we're thinking about games and more risk seeking when we're facing losses.
Speaker C:You got it.
Speaker C:Now let's go back to that certainty effect for a minute.
Speaker C:It gets even weirder when we start talking about things like insurance.
Speaker B:Insurance?
Speaker B:But isn't insurance all about managing risk and uncertainty?
Speaker C:It is.
Speaker C:But think about this.
Speaker C:What if there is a type of insurance called probabilistic insurance?
Speaker B:Probabilistic insurance?
Speaker B:I've never heard of that.
Speaker C:It's a theoretical concept, but basically, it means you pay to reduce the probability of a loss, but you don't eliminate it completely.
Speaker B:So, like, you cut your risk in half, but there's still a chance you could be on the hook for the whole thing.
Speaker C:Exactly.
Speaker C:From a purely mathematical standpoint, it's often a better deal than regular insurance because you pay lower premiums.
Speaker B:But knowing what we know now about the certainty effect, I bet Most people would still choose regular insurance.
Speaker C:You're right.
Speaker C:They did studies on this.
Speaker C:And people overwhelmingly reject probabilistic insurance because they want that certainty even if it costs them more.
Speaker B:Wow.
Speaker B:So even when it comes to protecting ourselves from risk, we still can't resist that craving for certainty.
Speaker C:It's just another example of how our emotions influence our decisions, even when logic says otherwise.
Speaker B:This is all starting to make a lot of sense.
Speaker B:So we've talked about the certainty effect, the reflection effect, and now this probabilistic insurance thing.
Speaker B:How does all of this fit together in prospect theory?
Speaker B:Like, what was Kahman and Tversky's big explanation for all these seemingly irrational behaviors?
Speaker C:Well, they came up with two main concepts, the value function and the weighting function.
Speaker B:Okay, I'm all ears.
Speaker B:Tell me about these functions.
Speaker C:So the value function that describes how we perceive gains and losses.
Speaker C:Like, remember how we talked about losses feeling more painful than gains?
Speaker B:Yeah.
Speaker B:That was a big aha moment for me.
Speaker C:The value function basically maps that out visually.
Speaker B:How does it do that?
Speaker C:It's like an S shaped curve.
Speaker C:For gains, convex.
Speaker C:For losses, concave.
Speaker B:Convex.
Speaker B:What does that mean?
Speaker C:It means that the curve is steeper for losses than for gains.
Speaker C:So a loss of a certain amount feels worse than a gain of the same amount feels good.
Speaker B:So the shape of the curve itself shows how our emotions color our perception of gains and losses.
Speaker C:Exactly.
Speaker C:And then there's the weighting function.
Speaker C:That one describes how we perceive probabilities.
Speaker B:Probabilities.
Speaker B:Like the odds of something happening.
Speaker C:Right.
Speaker C:And here's the thing.
Speaker C:We don't treat probabilities objectively like we should.
Speaker B:What do you mean?
Speaker C:I mean, we tend to overweight small probabilities and underweight large ones.
Speaker B:So we give too much importance to events that are unlikely and not enough importance to things that are more likely to happen.
Speaker C:Exactly.
Speaker C:It's like our brains have a hard time grasping the real significance of very small or very large probabilities.
Speaker B:Can you give me an example of that?
Speaker C:Sure.
Speaker C:Imagine you're forced to play Russian roulette.
Speaker B:Oh, God.
Speaker B:Okay.
Speaker C:But you can pay to have one bullet removed.
Speaker C:Would you pay more to reduce the number of bullets from 4 to 3 or from 1 to 0?
Speaker B:Ooh, that's a tough one.
Speaker C:Most people would pay way more to go from one bullet to zero, even though the reduction in risk is actually greater in the other scenario.
Speaker B:So it's like we see that one bullet.
Speaker C:Yeah.
Speaker B:And we're like, that's it.
Speaker B:I gotta get rid of that one bullet.
Speaker C:Right.
Speaker C:We overemphasize that small probability, and it distorts our perception of the risk.
Speaker B:Okay, so the weighting function is all about how we twist probabilities in our minds.
Speaker C:Pretty much.
Speaker C:And that has big implications for how we assess risks in real life.
Speaker B:You know, like we might overestimate the chances of winning the lottery or being in a plane crash.
Speaker C:Exactly, because those are vivid events, even though they're statistically unlikely.
Speaker B:So to sum it all up, prospect theory says that our decisions are driven by two main things.
Speaker B:Our emotional responses to gains and losses and our distorted perception of probabilities.
Speaker C:You got it.
Speaker C:And while this can sometimes lead to decisions that seem irrational, it's actually a pretty efficient way for our brains to handle all the uncertainty we face in the world.
Speaker B:It's like our brains are trying to simplify things to make sense of a complex world.
Speaker C:That's a good way to put it.
Speaker C:But the good news is that by understanding these tendencies, we can become more conscious decision makers.
Speaker B:So we can learn to override those automatic responses and make choices that are more in line with our goals.
Speaker C:Exactly.
Speaker C:And that's where the real power of prospect theory lies.
Speaker C:It's not about being perfectly rational.
Speaker C:It's about understanding how our brains work and using that knowledge to make better choices.
Speaker B:So let's talk about some real world applications of prospect theory.
Speaker B:How can this knowledge actually help us make better decisions in our lives?
Speaker C:Well, prospect theory can help us understand a ton of things, like why lotteries are so popular.
Speaker B:Okay.
Speaker B:Lotteries?
Speaker B:Yeah.
Speaker B:Why are people so drawn to them when the odds of winning are so tiny?
Speaker C:It's that value function and weighting function combo we talked about.
Speaker C:Like, we overweight those small probabilities.
Speaker C:They feel bigger in our minds.
Speaker B:Right.
Speaker B:So that tiny chance of winning big suddenly seems more real, more possible.
Speaker C:Exactly.
Speaker C:And then that potential gain, even if it's unlikely, it just holds so much value for us, Especially when we're feeling loss averse, you know?
Speaker B:Yeah.
Speaker B:It's like that dream of escaping our current situation.
Speaker B:Winning big could solve all our problems.
Speaker C:Right.
Speaker C:And that dream can be really powerful, even if it's based on a tiny probability.
Speaker B:So prospect theory explains why we buy those lottery tickets, even though we know deep down that the odds are stacked against us.
Speaker C:Yep.
Speaker C:And it can also explain why people hold on to losing stocks for way too long.
Speaker B:Oh, yeah, that's a classic example of loss aversion.
Speaker B:Right, like selling the stock means admitting that we made a bad decision and losing money.
Speaker C:Exactly.
Speaker C:And our brains hate that.
Speaker C:So we hold on Hoping for a turnaround even if it's unlikely.
Speaker B:So we're basically gambling on that small probability of recovering our losses instead of accepting the loss and moving on.
Speaker C:Right.
Speaker C:And understanding prospect theory can help us.
Speaker B:Avoid that trap by recognizing that we're being influenced by loss aversion and making a more rational decision based on the actual probabilities.
Speaker C:Exactly.
Speaker C:It's about detaching from the emotions and looking at the situation objectively.
Speaker B:Okay, so prospect theory can help us with investing.
Speaker B:What about other areas of life?
Speaker B:Like consumer choices?
Speaker C:Oh yeah.
Speaker C:It applies there too.
Speaker C:Like think about how marketers use framing effects to influence us.
Speaker B:Framing effects?
Speaker B:Remind me what that is.
Speaker C:It's how they present the choices to make one option seem more appealing even if the underlying value is the same.
Speaker B:Okay, right.
Speaker B:Like buy one, get one, free deals.
Speaker C:Exactly.
Speaker C:That free item suddenly seems super valuable even though you're still paying for the whole thing.
Speaker B:And we fall for it every time.
Speaker B:It's crazy how these little tricks can influence us.
Speaker C:It is.
Speaker C:But by understanding how they work, we can become more aware and less likely to be swayed by them.
Speaker B:So prospect theory is like a secret weapon for making better decisions in all areas of life?
Speaker C:I think so.
Speaker C:It's about understanding the psychology behind our choices and using that knowledge to our advantage.
Speaker B:This has been such a fascinating deep dive.
Speaker B:I feel like I have a whole new perspective on decision making.
Speaker C:Me too.
Speaker C:It really makes you think about how our brains work and how we can make them work better for us.
Speaker B:And I love that.
Speaker B:Kahneman and Tversky ended their paper with this thought provoking question.
Speaker B:How can you consciously adjust your reference point to make more advantageous decisions, particularly when facing potential losses?
Speaker C:That's such a powerful question.
Speaker C:It's like they're giving us a challenge to take control of our decision making.
Speaker B:To not be ruled by our emotions, but to choose how we frame the situation.
Speaker C:Right.
Speaker C:To consciously adjust our reference point so we can make the best choice possible.
Speaker B:I think that's a great takeaway for our listeners.
Speaker B:We have more power than we realize to shape our own decisions and our own lives.
Speaker C:Absolutely.
Speaker C:By understanding how our brains work, we can become more conscious, more intentional, and ultimately more successful in achieving our goals.
Speaker B:Well said.
Speaker B:Thank you so much for sharing your expertise with us today.
Speaker B:It's been a real pleasure.
Speaker C:The pleasure was all mine.
Speaker B:And to our listeners, thank you for joining us on this deep dive into prospect theory.
Speaker B:I hope you found it as enlightening as I did.
Speaker B:And I encourage you to keep exploring these ideas and see how you can apply them to your own life.
Speaker C:It's a journey of self discovery and it can lead to some amazing insights.
Speaker B:Until next time, stay curious.
Speaker B:Yeah, and keep those aha moments coming.
