A NEW ERA
Prospect Theory: Decision-Making Under Risk Read ≈ 4-5 minutes
To continue a recurring theme of the TS Lightbulb – I mentioned how a single thought triggered my subsequent immersion into Behavioral Science research; I've yet to reveal the trigger itself. Let's take it back to January 2016…
Between sales calls, I was listening to a Freakonomics podcast interview with a cognitive psychologist. They we're discussing a specific research paper titled, 'An Analysis of Decisions Under Risk.'
At that time, I had no prior knowledge of the psychologist, but the topic quickly grabbed my interest – for two primary reasons.
DECISIONS: I alluded to it with my whole 'build approach around decisions' sales mantra. I won't expand here as it's a topic you'll hear continuously; it was the last word in the paper triggered my main reaction at the time.
RISK: when I talk risk, most tend to think I'm referring to quitting big corporate, entrepreneurship, world travel, etc. That's natural and certainly not a wrong assessment; however, those thoughts typically don't enter the equation right away.
I've been a risk nerd for a long time, credited, near exclusively, to the primary solution I was selling – Group Long Term Disability Insurance (LTD).
I will save employee benefit talk for another medium, but, considering the unpredictably & big money on the line (both sides), there may be no product riskier,
So, with Group Insurance as my professional background, when I think risk, terms like persistency, loss ratio, and reserves are still very much top of mind.
The point being, while abnormal for a 25-year-old sales guy to get fired up hearing about a research paper on human decision-making, it wasn't too out of character.
Making a short story just a bit longer, I printed the original research paper upon returning to the office, read it the same evening, and – it changed my life.
While much of the science was over my head, the conclusions hit home right away. Being in an occupation that works with people and big purchase decisions, everything just made sense. This was the first research paper I ever read, and I didn't quite know what to do
OG PAPER
In January of 2016, I was listening to a podcast where they interviewed economist, Daniel Kahneman, about the research paper him and his partner, Amos Tversky, published in 1979 titled: “Prospect Theory: An Analysis of Decision Under Risk.”
I had no prior knowledge of Mr. Kahneman or the theory they discussed but it sounded interesting and it won them the Nobel Prize, so I thought it was worth checking it out. I decided to read the original paper that night. It changed my life. I even remember where I was; that’s how big of a “light bulb moment”.
As someone who was always a hater on sales books and models in general, I never had a true framework to my approach. I was just doing what I thought would give me the best chance to sell each case, but I didn’t have the proper rationale for doing what I was doing. Until now.
While I did have some sales success prior to this new breakthrough understanding, the more I read and dove into the world of behavioral science, the more everything started to click. I had finally found a method to my madness.
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Decision Science (Aug-2018)
This is the paper that really started it all for me.
Prospect Theory: Prospect theory is a behavioral model that shows how people decide between alternatives that involve risk and uncertainty.
Replacement of ‘utility theory’: commonly known as the “rational choice” or choice theory…
The choice theory essentially says that all humans base their decisions on rational calculations, act with rationality when choosing, and always make prudent logical and decision
The person who came up with that was clearly never in sales, otherwise he would know how far off he was. People simply don’t act rationally when choosing, it’s usually the exact opposite.
Level of Impact
When I read the original paper and up until I really dove deep into the subject, I didn’t really know the level of how impactful this paper really is.
I have read thousands of pages of various books and studies behind human decision-making and, I make no exaggeration, 100% of them mentioned prospect theory.
That caused me to google, ‘the most cited research papers’ and that’s when I realized the true importance of this paper.
Importance:
In the field of Economics and Psychology, Prospect Theory is the #1 most cited research paper of all-time… and it’s not even close.
In fact, it’s almost triple the amount of the 2nd most cited paper.
This Infographic – produced by Thomson Reuters, shows me two main things…
Growth of behavioral science: the original citation was when it was published in 1979 and as you can see has been a steady rise. The real growth started in 1999 and within the 10 years following, the number of citations had nearly tripled and it’s continuing to trend up since.
Reach across multiple industries: at the bottom, you can see that it’s not only used in economic texts, but it has a significant presence in the fields of business, law, management, and medicine.
Moral of the story… Don’t just take my word for it.
The findings within this paper have been used in virtually everything that has any sort of component involving decision-making.
I haven’t come across a publication specifically for professional sales, but I figured, why not add one more to the list?
Prospect Theory Breakthroughs
After over a decade of research and studies, Tversky & Kahneman concluded the following about how humans make decisions.
Two Phases: Two phases in the choice process: an early phase of editing and a subsequent phase of evaluation.
The purpose of the editing phase is to organize and reformulate the options, in order to simplify succeeding evaluation and choice.
Irrational Mind: When we make decisions, we don’t always make them rationally.
They identified how our minds use mental shortcuts, to make a decision that, may not be optimal, but more so “good enough.” Those are called heuristics and the next part will review this in greater detail.
Reference Point: The evaluation of choice is relative to a neutral reference point.
In most cases, it’s what they have currently, or what the status quo is perceived to be.
Gains & Losses: We define outcomes as gains and losses, rather than states of wealth.
Those gains and losses are going to be how they are perceived by the decision maker, relative to his/her reference point.
Loss Averse: Risk aversion is changed to risk seeking, when the focus is changed to losses instead of gains
In the human mind, losses loom larger than gains.
Closing: These are still considered the framework behind how someone makes a decision. Denying it would be similar to denying climate change or the world being round… There’s people who might do it, but they’re just wrong.
Transition: Those findings are going to act as the main foundation of everything we talk about and will brought up throughout the presentation. As I said in the intro, before we can learn how to better influence a decision, it’s important to understand the science behind how someone makes a decision. It’s time to dive in!