Prospect Theory

Summary of the learning points (ranked by importance to you)

Today’s class discussed the mental accounting for money management.

1. Prospect theory. The theory can be represented by a value function, as shown below. The value function starts from a reference point, and is normally concave for gains, and convex for losses. It is also steeper for losses than for gains. The theory intends to explain why people behave irrationally when making choices.

2. Framing effect. It refers to the difference in response to the same question represented in different ways. This technique is frequently used in marketing ads campaign, such as PAD.

3. Sunk-Cost effect. When people have put effort into something, they are often reluctant to pull out because of the loss that they will make, even if continued refusal to jump ship will lead to even more loss.

How you have, or will you use these lessons in your work life?

Prospect theory suggests “aggregate losses and segregate gains”. It can be applied into trivial daily activities or significant decision making in project planning at work. For example, my boss probably will not approve my one-month vacation request. However, he is more likely to approve if it is in the form of a series of applications for five days each month over the next half year period. As for product launch plan, even though the company developing on multiple products at the same time, but the product launch is always spreading out instead of bundling together. By doing so, the stockholder has more confidence in our company because they constantly receive good news, the stock price increases accordingly.

Prospect theory also implies sometimes it’s better to take losses all at once. This is the sunk cost effect. It explains why I still hold on to Nortel stock after it hit bottom, hoping that the stock will go up someday. I should have sold it, take the loss and seek out alternative investments. As for my previous work place, I still vividly remember the first generation product I worked on. Because the company was relatively new in the market, half-way through our developing stage, our market research showed that we integrated too many features into the product, therefore the cost was too high, resulting our pricing will be considerably higher than the competitor. Given all the work that had gone into the design, the management decided to continue on the project. As predicted the final product was not well received on the market, and because of the limited resources, we did have enough people working on the next generations either. As I looked back now, I think it would be more appropriate to cancel that project, take the loss and focus on the second generation product, so that we could beat our competition to be first one to launch the product.

A particularly useful or interesting insight that you realized and want to record