Today, I want to talk about Prospect Theory. I’ve been hinting at it around the edges, talking about loss aversion and general craziness, but I think it’s time.

“Prospect Theory” is the fancy name for the life epiphany that Daniel Kahneman and Amos Tversky mutually experienced while going for long walks through the side-streets of Jerusalem. Unfortunately, Amos Tversky died before he could collect the Nobel prize that accompanied said epiphany – but Mr Kahneman picked his up in 2002.

The starting point for Prospect Theory was the question: “Is anyone intuitively good at statistics?”

And it’s an important question because we spend a lot of time trying to assess the odds of things happening or not happening as the case may be – but assessing the odds is only useful if you can use them correctly. In much the same way as it’d be wonderful to fly but significantly less so if you’re flying blind.

Unfortunately, as it turns out, we’re pretty sh*t at statistics.

The Scenarios

Any Prospect Theory thought experiment requires a framework, so let’s do that. In any risky situation, you look at two things:

• The likelihood of success/failure (the probability); and
• The potential gain/loss (the payoff).

The probability can be high or low. The payoff can be positive or negative. You’re left with a box (or matrix) of options that looks something like this:

Now that there is a matrix, it needs to be populated. So to do that, here is a thought experiment:

1. Let’s assume that you’re a gay man – a fairly fabulous one that dresses a lot like Adam Lambert.
2. Foolishly, you visit one of the following places:
1. Iran
2. Mauritania
3. Saudi Arabia
4. Sudan
5. Yemen
6. Anywhere in Nigeria that is governed by Shari’a Law
3. You’re followed from the airport to your hotel, and get arrested the next morning on the bogus charge of having had “unnatural relations” with a prominent civil rights activist.
4. The arresting officer apologises to you, telling you that the whole thing is politically motivated, “but such is life.”

Scenario 1: High Probability of Gain

You’re sitting in a cell, when your court-appointed lawyer comes to you and says:

“So listen, this is really all a misunderstanding. Some eager young imam was trying to prove himself, and it seems that he got out of control. What I’m being told is that if you’re prepared to admit to indecency and accept 10 public lashes in order to help the ayatollahs save face, then they’ll let you go home. If you fight it, there’s, like, a 95% chance that they’ll drop the charges and pay you some damages for your trouble. But there’s still a small chance that if you head down that route, they might get irritated and make things difficult.”

What would you do? You’d probably take the indecency rap, bear the lashes and go home. Or, in more portentous terms, your fear of disappointment/difficulty would make you risk averse, and you’d accept the unfavourable settlement.

Scenario 2: Low Probability of Gain

The lawyer comes to you and says something slightly different:

“So this is really all a misunderstanding. What I’m being told is that if you’re prepared to admit to indecency in order to help the imams save face, then they’ll forget the whole thing and you can go straight home. But I think that they really just want this to go away – apparently, there are some international sensitivities in a trade negotiation that could be affected. If you try and fight it, then there’s a small (say, 5%) chance that they’ll actually pay you anything between \$50,000 and \$100,000 to go home tonight, just to get this off the radar…”

In this case, the small chance of getting quite a large cash settlement would probably entice you to fight the case. That is: the hope of large gain would make you risk seeking, and you’d reject a favourable settlement.

Scenario 3: Low Probability of Loss

In a somewhat less optimistic tone, you get told:

“The school of clerics are annoyed. Their hand has been forced here – but that’s all spilt milk, really. They have said that you must admit to indecency, accept 10 public lashes, and then go home. I think that if you push it, you’ll get off. But if someone gets it into their head to make an example out of you, then there’s about a 5% chance that you’ll get the death penalty.”

There is not even a pause for thought here. You’d take the lashes and leave ASAP. The fear of a large loss death makes you risk averse, and you take the unfavourable settlement.

Scenario 4: High Probability of Loss

This is what you definitely wouldn’t want to hear:

“I’m really sorry, my boy. The clerics are determined to see this through. They’ve forced some people to be witnesses by threatening family members. But they’re prepared to let you have life imprisonment if you just admit to everything upfront. If you fight it, there’s maybe a 5% chance that you can get off and go home – but if we do that and you lose, then it’s straight to the execution block. They’ve made that very clear – no leniency.”

In this case, the hard truth is that you’d probably fight it. The small chance of gain makes this the kind of underdog out-of-nowhere scenario that movies are made of. The hope to avoid life in prison makes you risk-seeking, and you reject the (marginally) favourable settlement.

A Populated Matrix:

How That Plays Out In The Business World

Picture these two peoples/entities on opposite sides of the negotiating table:

• Someone with a low probability of a high gain; and
• Someone with low probability of a high loss.
• While always remembering that one person’s gain is another person’s loss…

The net result is frivolous law suits.

On one side, you have the plaintiff that has high hopes of getting one over the big corporation; and on the other side, you have the big corporation that doesn’t want to pay large amounts in damages because some jury stupidly decided that people need to be warned that coffee is hot.

How That Plays Out In The Office

Most people live in fear of being fired for not working hard enough. Even though the odds of that happening are quite low. After all, it’s usually quite difficult just to fire someone – there are usually disciplinary hearings and warnings and arbitrations. But that tends to pale next to the fear, which leaves the power unfairly balanced in a supervisor’s hands…

And if that supervisor could be up for a big promotion if he pulls off some good deals, then expect to be doing a lot of work for his promotion…

But where this can get really dangerous is when you have a supervisor whose job is on the line. Because now – now you have someone cornered by circumstance with very little to lose.

And there’s no telling what Hail Mary pass he might throw.

Rolling Alpha posts opinions on finance, economics, and the corporate life in general. Follow me on Twitter @RollingAlpha, and on Facebook at www.facebook.com/rollingalpha.