Prospect theory in financial decision-making

What is prospect theory?

Prospect theory is a concept describing a process by which people make financial, purchasing, investment, etc. decisions. It assumes that profit and loss are valued differently. More specifically, people are more willing to take risks if the chance of gain is greater than the prospect of loss. According to the founders of this theory – Tversky and Kahneman – people are more likely to experience negative emotions associated with a loss than positive feelings associated with a gain.

It is easy to illustrate with a simple example:

Given a choice of options:

1. Sure win of $100
2. 50% chance of winning $200 or 0

Most people will choose option 1. On the other hand, given a choice:

1. A certain loss of $100
2. 50% chance of losing $200 or 0

Most people will choose the second option.

In this theory, we can talk about several phenomena that affect a person’s final decision:

The effect of certainty

It refers to favoring certain events over highly probable ones. People are more likely to choose options with a certain profit than options with a lower probability but higher profit. This is because people are averse to losing and experiencing it much more severely than success – so they remain in a safe comfort zone. This is also noticeable in the case of loyalty to a particular brand and a bias against other companies whose offerings might prove better.

Reflection effect

Make decisions that will minimize losses, even if the chance of their occurrence is negligible.

Isolation effect

Also called framing. It involves changing preferences depending on how a given option is presented. People are more likely to focus on the differences rather than the similarities of given options, which is usually easier for them. This leads to different perspectives and influences the final decision.

The effect of a stronger

Also known as the Bandwagon effect – acting or thinking in such a way that it is consistent with another group of people. It is related to the social proof of rightness.

Prospect theory examples

How can you use your knowledge of prospect theory in your business to influence the decision-making of potential consumers? Here are some hints!

1. Offer a discount on future purchases if the customer subscribes to your mailing list (you create an effect of certainty that they will receive a certain benefit).
2. Encourage people to buy more than one copy of a product by providing them with a discount.
Offer free shipping above a certain order value, which can motivate consumers to buy more products.
3. Create a loyalty program and from time to time reward, for example, with discounts, or free products to your most loyal customers who regularly shop with you or the value of their shopping cart is one of the highest.
4. If you want to draw the customer’s attention to the messages in question, use a different font, color, or larger size than usual to make them stand out.
5. When using CTAs (calls to action), mark them with contrasting colors to catch the eye.
6. Invoke so-called FOMO, or fear of missing an opportunity, in your communications. Put your offers in the category of losses rather than gains, e.g. Don’t miss the opportunity! The promotion is valid only until midnight.
7. Offer trial periods/versions, for example, so that the customer, without fear of risking a loss, will take advantage of your offer and become convinced. You can also guarantee a refund if the consumer is not satisfied with the purchase. This will increase their sense of security and reduce fear of potential loss.
8. Publish positive reviews about your products or services. Potential customers often look for other people’s reviews before buying, so make sure they are visible but also credible.
9. Cooperate with influencers and public figures. Because famous people are watched by many people on the Internet, it is worthwhile to establish cooperation with them to promote products. Their positive opinion can positively influence the increase of sales in your business.
10. Refer to the so-called Rule of 100. It says that if your product has a value up to $ 100, its price reduction should be communicated in percentage terms (e.g. discount -20%). On the other hand, if the price of the product exceeds $100, present the price reduction numerically (e.g. discount – $20). This way of presenting promotions is perceived as more attractive.

Prospect theory – summary

Prospect theory is a concept worth knowing, especially if you are an entrepreneur or investor. By learning about the behaviors and emotions that drive people during the buying process, you can elicit the reactions you want from them and create effective pricing strategies. In turn, people who invest in the stock market, for example, can better understand their reactions and make more accurate financial decisions.

Read also: Strategies for Effective Business Meetings

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