Following the schedule of our Reading Calendar
This chapter presents us with a detailed description of prospect theory which should address the deficiencies that, as we saw in chapter 25, the 250 year-old utility theory presented.
Instead of calculating the utility that a certain amount of money represents for a person just putting it in relation with the person’s wealth, prospect theory uses a different approach to predict human preferences. It is based in three principles:
1. Evaluation is relative to a neutral reference point which is not the wealth of the person involved but is a characteristics of the choice presented to it and the expectations of gains and losses that it generates.
2. There is diminishing sensitivities to both losses and gains.
3. Perceived utility is asymmetrical for gains and losses being much bigger for the latter. This is loss aversion and is the basic point of the chapter.
Here comes to my mind Taleb, the story teller, when he explains that if you look at your portfolio once in a year, you see that you are up 5% and you are happy. But if you look everyday, almost half of the days you are losing money and you live a miserable life because the bad feelings that you get are not offset by what you get the days that you are up.
And talking of Taleb the Impaler, the chapter ends with a strange final section where the Kahneman tries somehow to recover the value of utility theory after all the bashing that it has received in the last two chapters. I kind of false modesty, probably, to soften relationships with some colleges. This is something Taleb has never done.
God bless him.