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Guide to Prospect Theory

Both running a business and purchasing products or services as a customer involve a number of different decisions. Therefore, to run a successful business and improve financial viability, it stands to reason that you should get a better understanding of how these decisions work. There are a number of different psychological theories that seek to explain this, and one of the most significant ones is prospect theory. In a nutshell, prospect theory is an analysis of decision under risk. In other words, it explains how humans make decisions in relation to risk management.

You might be wondering how prospect theory, psychology and other abstract concepts can benefit your business. After all, when doing business, you are also dealing with human behaviour and relationships. For this reason, a psychological understanding of how decisions are made can help you to create a great business model. Read on to find out more about prospect theory and how it can help your company.

Prospect theory definition

The prospect theory definition is not simple and requires some in-depth reading for a full understanding. However, the basics are as follows:

Prospect theory, an analysis of decision under risk, is a theory in behavioural economics and was first proposed by Amos Tversky and Daniel Kahneman in 1979. The theory explains that decision making is based upon the analysis of losses and gains and the emotional impact that these have. In addition, these choices are not always rational, but they are generally quite predictable. Individuals perceive losses as having a greater impact than the equivalent amount of gains, and this affects the decision-making process.

Examples of prospect theory

For a clearer idea, some examples of prospect theory in real life are useful. Let’s say a person is offered two options: in the first option, they are offered $100 dollars, but must give $50 of this away to a third party. In the second option, the person is offered $50 and is able to keep the full amount. In this case, they are likely to prefer the second option because there are no perceived losses, despite the end result of gaining $50 being exactly the same.

Another example of prospect theory in real life could relate to investment in a mutual fund and how this is presented. One advisor may present a mutual fund to a potential investor, claiming that it has had good returns over the last decade but also that it has been declining in the last two years. Another advisor may present the same fund and report that it has had an average return of 15% over the past three years. Investors would be much more likely to invest with the second advisor, as the fund was presented only in terms of gains.

How to apply prospect theory psychology in your business

So now you understand what prospect theory is, but how can it help you to run your business? A good understanding of this psychology and how people tend to have an aversion to loss can have a positive impact in various areas:

  • Offer certainty to your customers. People generally prefer to have smaller gains that are certain than take a risk for the possibility of larger gains. This could apply for customer rewards: rather than offering them the chance to participate in a competition to win $1000, give customers a definite discount on their next purchase.

  • Highlight losses that customers may face if they do not purchase your product or service. For example, for insurance companies, you could highlight the huge costs of various incidents and contrast these to the small loss of a regular monthly payment.

  • Protect your customers against bad experiences. Since loss has such a negative emotional impact, this can damage the customer relationship significantly more than a positive experience improves it. For this reason, you should work hard to avoid any potential issues for your customers.

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