Prospect theory describes two key insights from behavioral economics: 1) people perceive outcomes as gains or losses rather than absolute wealth levels and 2) people are risk averse for gains but risk seeking for losses. The greatest limitation of prospect theory is that it does not provide precise quantitative predictions of behavior. The document then describes several cognitive biases related to perception, including saliency, framing, anchoring, and sunk costs.

1. Prospect Theory

2. PERCEPTION BASIS
Section IV
Markets
Describe two insights from
prospect theory
 Describe the single greatest
limitation of prospect theory

3. Perception Basis
A perception bias arises when an individual has difficulty figuring out what
the problem is that needs to be solved. Perception biases come in many
forms.
Saliency Framing
Anchoring
Sunk Cost
Basis

4. Saliency
 we have a tendency to ignore that thing even if it is important to an upcoming
decision.
 No one seems interested in buying flood insurance unless there has been a
recent flood.
Saliency works in two ways.
1. If an event has not occurred recently, then that event tends to be perceived
as having zero or negligible probability of occurring in the future.
2. If the same event has occurred very recently, the perceived probability of a
future occurrence becomes overstated.
the occurrence of “bad” economic states seems to be perceived as almost
impossible when the economy is strong and the demand for credit is high.

5. Framing
 The simplest setting for framing is the consideration of alternative policies that
involve an unavoidable loss of life
Problem 1.
Imagine that the country is preparing for the outbreak of an unusual disease, which is
expected to kill 600 people. Which of the following programs would you favor?
Program A: Has the effect of saving 200 people.
Program B: Has a 1/3 chance of saving 600 people and a 2/3 chance that no one will be
saved.
(Most people will choose Program A when given the choice)
 Program C: 400 people will die for certain.
Program D: 1/3 chance that no one will die and 2/3 chance that 600 people will die.
(Most people will choose Program A & C)

6. Framing
In Problem 1, respondents think of each person they save as a gain, and therefore
make the risk-averse choice—saving 200 people for sure is more palatable than
taking the chance that everyone might die.
In Problem 2, respondents think of each person that dies as a loss, so they make
the risk-loving choice. Sending 400 people to their deaths seems rather
Draconian when the other option presents a reasonable chance that all might
live.

7. Framing
Problem 3
Program E: 25 percent chance to win $240 and 75 percent chance to lose $760.
Program F: 25 percent chance to win $250 and 75 percent chance to lose $750.
In Problem 3, virtually everyone will choose F over E since F dominates E.
The rational and proper choice is F.
Problem 4
Imagine that you face the following pair of concurrent decisions. First, examine both
decisions, then indicate the options you prefer.
Decision (i)—choose between:
A. sure gain of $240.
B. 25 percent chance to gain $1,000 and 75 percent chance to gain nothing.
Decision (ii)—choose between:
C. A sure loss of $750.
D. 75 percent chance to lose $1,000 and 25 percent chance to lose nothing.

8. Framing
Framing is doing is exploiting our attitude toward bad events.
In the first example, respondents do not wish to do harm. Therefore, when the
choice is between saving people and rolling the dice, respondents want to save
people. But when the identical choice set is presented and framed as if the
respondent is choosing that 400 people will die with certainty, respondents go for
the choice that presents the possibility of saving everyone, even though all 600
might die. Perception is the key.
In Monetary Position Framing is taking advantage of loss aversion in Problems 3
and 4. Most respondents choose A, expressing risk aversion, and D expressing
risk seeking. Such choices are routine to loss aversion.

9. Anchoring
Anchoring bias in decision-making. Anchoring or focalism is a term used in
psychology to describe the common human tendency to rely too heavily, or
"anchor," on one trait or piece of information when making decisions.
the investor is anchoring on a recent "high" that the stock has achieved and
consequently believes that the drop in price provides an opportunity to buy the
stock at a discount.
For instance, suppose that XYZ stock had very strong revenue in the last year,
causing its share price to shoot up from $25 to $80. Unfortunately, one of the
company's major customers, who contributed to 50% of XYZ's revenue, had
decided not to renew its purchasing agreement with XYZ. This change of events
causes a drop in XYZ's share price from $80 to $40.

10. Anchoring
By anchoring to the previous high of $80 and the current price of $40, the
investor erroneously believes that XYZ is undervalued. Keep in mind that XYZ is
not being sold at a discount, instead the drop in share value is attributed to a
change to XYZ's fundamentals (loss of revenue from a big customer). In this
example, the investor has fallen prey to the dangers of anchoring.
Successful investors don't just base their decisions on one or two benchmarks,
they evaluate each company from a variety of perspectives in order to derive the
truest picture of the investment landscape.

11. Sunk Cost Basis
• A sunk cost is a cost that has already been incurred and thus cannot
be recovered.
• A sunk cost differs from future costs that a business may face, such
as decisions about inventory purchase costs or product pricing.
• The decision to pay for a ticket to attend a future event is based on
expectations about the utility of that future event.
• Having paid for the ticket, once the future event arrives, you must
make a new decision—should you attend or not?
• What you paid for the ticket earlier should be irrelevant, economists
argue, to the decision to attend.

12. Sunk Cost Basis
• Sunk costs involve regret, the bias that results is similar to the bias an investor
shows when reluctant to purchase a stock after missing the opportunity to buy
the stock at a cheaper price.
• Investors who “go to cash” in the midst of a financial crisis are sometimes
disappointed that, after they sell out, stocks rally to higher prices.
• Will they get back in? Often, the answer is no.
• The investor will wait and hope that stocks fall back to the levels at which they
had made their earlier exit.
• What if that never happens? Then investors may wait until the regret they feel
from not getting back in goes away.
• Once the feeling of regret is no longer present simply because of the passage of
time, the investor might invest again, often at much higher prices.

13. Inertia Effect
Section IV
Markets
Endorment Effect
Status Quo Effect
Disposition Effect

14. Endowment Effect
• Imagine two identical people making a choice between two options, option A
and option B. The only difference between the two people is that the first starts
at A and is asked whether or not he or she would like to move to B, whereas the
second starts at B and is offered the ability to move to A.
• The endowment effect, in behavioral finance, describes a circumstance in which
an individual values something that they already own more than something
that they do not yet own.
• Investors, therefore, tend to stick with certain assets because of familiarity &
comfort, even if they are inappropriate or become unprofitable. The
endowment effect is an example of an emotional bias.

15. Status Quo Effect
• Status quo bias is evident when people prefer things to stay the same by doing
nothing (see also inertia) or by sticking with a decision made previously
• In economics, status quo bias can cause individuals to make seemingly non-
rational decisions to stay with a sub-optimal situation.
• Examples of status quo bias
- Choosing default option
- Preference for old plans
- Brand allegiance

16. Why people prefer the Status Quo
• Endowment effect - In behavioural
economics, we can observe a preference
for people to give a higher weighting to
what they already have. We become
attached to our current situation and
goods.
• Fear of unknown - Psychologically people
may express a feeling of ‘better the devil
you know.’ In other words, people dislike
uncertainty and are risk averse at making
a choice.
• Costs of making choices - Suppose every
day you drink at Starbucks. The Coffee is
good. It could be better, but it could be
worse.

17. Why people prefer the Status Quo
• Inertia. - People may simply not want the hassle of changing.
• Repeated exposure gives familiarity and attachment - If we experience
something every day, we develop an attachment to the good. For example, if we
take a daily paper, we become a loyal reader
• Loyalty - An aspect of human nature is loyalty. If we support one sports team,
we have a reluctance to change.
Is status quo bias rational or irrational?
• If we stick with current choices to avoid costs of making decisions, then it can
be seen as a rational choice as we save calculation costs. However, if we refuse
to consider alternatives on the basis we only want to stay with what we have
then it becomes more irrational.

18. Disposition Effect
• The disposition effect is an anomaly discovered in behavioral finance.
• It relates to the tendency of investors to sell shares whose price has increased,
while keeping assets that have dropped in value.
• It is possible to minimize the disposition effect by using a concept called
hedonic framing to change your mental approach.
For example, in situations where you have a choice of thinking of something as
one large gain or as a number of smaller gains (such as finding $100 versus
finding a $50 bill from two places), thinking of the latter can maximize the
amount of positive utility.