Prospect Theory: A Logical Basis for "Illogical" Behavior

Prospect theory arises out research showing that people tend to take smaller risks in exploring opportunities and larger risk in defending against losses. Prospect theory says that people are risk adverse in pursuing opportunities while risk seeking in defending against losses. While researchers describe this behavior irrational, it does have a rational basis as a basic instinct for good strategy.

Much of the scientific research we use to teach strategy is based on the cognitive biases that shape our decision-making. In most cases, these biases systematically create strategic leverage points. Prospect theory is certainly one of those biases, especially since, if we want to encourage others taking investing in an action, we can frame choices in terms of potential losses instead of gains (2.3.3 Range of Reactions).

However, strategy puts a higher priority on defending existing positions rather than advancing them (5.6.1 Defense Priority). Strategy also recognizes an inherent difference in the quality knowledge that we usually have regarding defending an existing position as opposed to advancing our position into new areas.

Our knowledge about existing positions is infinitely better than our knowledge about potential future position. While at least the historical value of current positions is known, the value of potential positions is inherently unknowable (3.1.5 Unpredictable Value). Even if the "risks" seem the same in looking at future losses and gains, the quality of our knowledge is not the same. We know what we have much better than we can not what we do not have.

Because of this, strategy teaches us to minimize our initial investments in opportunities until they are proven to be profitable (5.0 Minimizing Mistakes). This matches exactly with what prospect theory shows about people preferring smaller investment to make making gains that in preventing losses.

While prospect theory can explain some truly illogical behavior--such as making bigger bets in games of chance to get even, our basic gut instinct to invest more in defense than offense is more often correct than wrong.