Monday, March 23, 2009

Prospect Theory Explains Everything, Nothing


I was reading this quote from Kahneman and Tversky, and found this part very revealing:
Low probabilities, however, are overweighted, and very low probabilities are either overweighted quite grossly or neglected altogether, making the decision weights highly unstable in that region.[page 8, Choices, Values and Frames]

Given this definition, I don't see why this theory is considered useful. If a disaster happens that seems to cause a lot of angst, one can say it was underweighted. If someone is paying a lot for insurance that seems to generate a positive return, one can say people are overestimating this risk. Ex post, the theory explains everything, and nothing. Looking a small probability event before the fact, it predicts everything, and nothing.

3 comments:

Anonymous said...

Prospect theory is nicely summarized as losses loom larger than gains ... while interesting it does not offer a solution that is materially different from more standard economic models ... in addition the calibration of the models suffer from the same problems more standard economic models suffer from ... I am thus at a loss for why prospect tehory draws much attention

Jeff Borack said...

The end of that paragraph says "consequently, people are often risk seeking in dealing with improbable gains and risk averse in dealing with unlikely losses. Thus, the characteristics of decision weights contribute to the attractiveness of both lottery tickets and insurance policies"

low probabilities are either overweighted quite grossly or neglected altogether depending upon whether we're viewing them from a potential gain or loss point of view.

eric falkenstein said...

But that assumes we overweight the small improbable event in both cases. That's one aspect of Prospect theory. The other is, ignoring small probability events, which is used selectively for other things. I agree it explains everything, but that's why its useless.