Have you ever found yourself in a situation where you’re left wondering why you opted for one financial choice over another, even when the outcomes appeared to be equally favourable? Well, that’s the result of prospect theory at work. Instead of just looking at the numbers, we tend to evaluate situations in terms of potential gains and losses. Here, emotions tend to have a stronger pull than logic and rational thinking when we make certain decisions.
What is prospect theory?
Prospect theory is a psychological framework that explains how people make decisions involving risk and uncertainty (Kahneman, 1979). In a nutshell, it suggests that our decisions aren’t solely about the final outcome but rather about the possible gains and losses – we’re more afraid of potential losses than we are enthusiastic about potential gains.
For instance, imagine you have a choice between two investment opportunities: one with a guaranteed return of $500 and another with a 50% chance of gaining $1,000. Prospect theory suggests that most people would choose the guaranteed $500 in order to avoid the loss, even though there is a possibility of gaining a larger reward for taking a risk.
Why does it happen?
Prospect theory occurs due to cognitive biases that influence how people perceive and evaluate choices (Kahneman, 1979). Loss aversion is a central component, where people tend to overweigh potential losses compared to equivalent gains.
Furthermore, framing effects, which involve presenting information in different ways, can significantly impact decision-making. For instance, offering a discount with a “save $100” versus “10% off” can yield different results, even though the financial outcome can be identical. This is because the framing of information influences how people perceive the choice.
How can the prospect theory be applied to digital banking?
A core tenant of prospect theory is that the positive feeling associated with a gain tends to reduce over time. In order to maintain the positive feeling of gains for longer, financial institutions should break up gains into smaller parts and provide customers with a visual representation of each gain to maintain engagement throughout the journey. If providing behaviour-based incentives to customers, financial institutions should consider breaking them down into smaller bitesize rewards that are shared within a certain timeframe rather than all at once.
Considering that most people tend to avoid losses, financial institutions should consider how they frame the messaging around products and services they are offering. Instead of focusing on the gains, financial institutions can create messaging that promotes avoiding a potential loss. For example, rather than “gain 1% interest by switching to xx account”, consider this messaging “Don’t lose out on 1% interest by staying with your current bank account”.