How a Change of Perspective Can Improve Your Decisions
Understanding reference dependence and loss aversion in everyday choices.
Posted December 31, 2018 | Reviewed by Ekua Hagan
Last time, we began exploring some of the ways that our thought processes can impact our own decision-making (and be used to persuade other people too). Specifically, we looked at a dual-process model of cognition, where such decision-making is modeled and simplified as either making quick decisions (system 1), or think more carefully through them (system 2). From there, we also evaluated how to persuade individuals in each of those modes of thinking as well.
Nevertheless, that is not the only aspect of our thinking that can impact our decisions. For example, the perspective through which we are viewing a choice (sometimes called a reference point, or frame of reference) can also influence the ultimate decision that we make. Therefore, to continue to help you make better choices, we will explore this "reference dependence" and various perspectives in decision-making more below too...
Reference Dependence and Loss Aversion
To understand this decision-making dynamic, it is best to begin where it was originally studied years ago, by Kahneman and Tversky (1979). The pair were interested in exploring why people's actual choices often differed from what traditional Economic theory predicted. Specifically, they were testing why people sometimes deviated from the logical and rational perspective predicted by Expected Utility Theory.
To test these dynamics, Kahneman and Tversky (1979) asked participants to select their preferences from a series of choices. Each choice was written from a different perspective as well. For example (Kahneman & Tversky, 1979, p. 273):
Problem 11: In addition to whatever you own, you have been given 1,000. You are now asked to choose between
A: (1,000, .50) [a 50% chance of gaining 1,000]
B: (500) [a 100% chance of gaining 500]
Problem 12: In addition to whatever you own, you have been given 2,000. You are now asked to choose between
C: (-1,000, .50) [a 50% chance of losing 1,000]
D: (-500) [a 100% chance of losing 500]
As we can see with some calculations, the probable outcomes for all four choices are the same. In each case, on average, the individual will be predicted to walk away with 1,500 (through the combination of what they are given at the start of the question and gain/lose with the choice they make thereafter).
- A: 1,000 + (1,000 x .50) = 1,000 + 500 = 1,500
- B: 1,000 + 500 = 1,500
- C: 2,000 - (1,000 x .50) = 2,000 - 500 = 1,500
- D: 2,000 - 500 = 1,500
Therefore, from a rational perspective, all of the options are equal. In contrast to that logical prediction though, Kahneman and Tversky (1979) found something very different. The point of reference included in the question (e.g. being given 1,000 or 2,000), as well as whether the individual was gaining or losing something from that point of reference, had an impact on the preference of participants. Specifically, when individuals were starting with a lower reference point and considering a choice among gains (problem 11), 84% chose a sure gain of 500 (option B). In contrast, when individuals were starting from a higher reference point and considering a choice among losses (problem 12), 69% chose the equal gamble of losing nothing or 1,000 (option C).
Those results indicated that individuals did not make decisions from a completely rational and universal perspective. Instead, they made choices based on considering various changes from the vantage point of their current situation or perspective (Reference Dependence). Also, they considered losses and gains differently too--often choosing "sure things" to secure gains, but preferring risky gambles to try to avoid losses of similar magnitude (Loss Aversion).
This dynamic was evaluated by Tversky and Kahneman (1981) again, with a different set of questions. In this case, participants were presented with the following scenario:
Imagine that the United States is preparing for the outbreak of an unusual Asian disease, which is expected to kill 600 people. Two alternative programs to combat the disease have been proposed. Assume that the exact scientific estimates of the consequences of the program are as follows:
If Program A is adopted, 200 people will be saved.
If Program B is adopted, there is a one-third probability that 600 people will be saved and a two-thirds probability that no people will be saved.
Alternatively, other participants received this framing of the choices instead...
If Program A' is adopted, 400 people will die.
If Program B' is adopted, there is a one-third probability that nobody will die and a two-thirds probability that 600 people will die.
Here again, although the average outcome for all choices were equal, the frame of reference from which the options were described made a difference in the preference of participants. Specifically, in the first set of options, more participants chose Program A to secure the sure gain. In contrast, in the second set of options, more participants chose the riskier Program B' to try and avoid the loss.
Beyond these initial experiments, decades of research has supported this general phenomenon in all kinds of decision-making (Kahneman, 2003). For example, such framing has been shown to impact financial and investment choices, as well as individual consumer and savings decisions (Barberis, 2013). Therefore, when contemplating your options in any decision-making scenario, it is helpful to consider your frame of reference and point of view too!
Applying the Right Perspective(s)
Should you sell that stock? Is this the right time to take that new job? How can you tell? These decisions can b aided by considering things from the right perspectives...
1. Take stock of what you really have.
As humans, we have the amazing ability to remember a lot about our past and imagine vivid plans for our future. In doing so, however, we can sometimes get stuck in those perspectives too, which may not be the most accurate point from which to judge our current choices. For example, an individual stuck focusing on their failures in their younger years might not fully take into account their current skills and achievements. In contrast, someone hoping for a year-end bonus might make a big purchase, before that bonus check is actually received (and cashed).
So, when making a decision, it helps to start with a perspective that most accurately evaluates your current situation. Usually, that takes into account the things that are tangible and real in the present moment. In other words, if the "chickens have not hatched yet," you cannot count them...but, if they have hatched, then do add them up. Given that, until you have actually received the bonus check, you may want to wait on the big purchase. Nevertheless, if your updated resume got you a handful of appealing job offers, then it might be time to see yourself as experienced enough to consider moving up from your current job.
2. Look at everything as both losses and gains.
When making decisions, people tend to consider the "pros and cons" of various options. While that is a good general strategy to start, thinking about the various options from both a gain and loss perspective is also helpful. After all, a "pro" for one option can be a gain (if you pick that option) or a loss (if you don't).
Let's go back to the job scenario as an example here. The individual might see financial security as a "pro" of staying with their current job. Thus, from that perspective, they would be gaining security by staying and losing it by leaving (likely leading toward motivation to stay—to avoid the loss of security). Nevertheless, they might see career advancement as a "pro" of moving to a new job. From that perspective, they would be gaining advancement by leaving and missing out by staying in their current job (likely leading toward a motivation to leave—to avoid the loss of advancement).
Therefore, by looking at all options from both a gain and loss perspective, you can help to balance out your motivations. This will decrease the likelihood of you "tricking" yourself into concluding one option is better than the other, simply by the way you are thinking about it—and not because it is actually better. As a result, it will make your overall decision-making more comprehensive and thoughtful too.
3. Consider what you want to ensure or gamble.
After taking both points above into consideration, you will have a better understanding of the decision you are facing—and the various options presented to you. Nevertheless, there is one final factor to consider. In most decisions, there are options that help to ensure things are more (or less) likely than others. In some situations, such a risk or gamble is appealing...in others, it is not.
This can best be exemplified by the original Kahneman and Tversky (1979) examples. While all options (on average) may lead to the same outcome, in some choices that outcome is certain, while in other choices it is not. Therefore, if walking away from a situation with exactly 1,500 is important to you (and not less), then you might want to pick the option that is most likely to ensure it. On the other hand, if you won't be able to sleep at night unless you take the gamble to save everyone from that disease, then you might want to risk trying choosing that cure.
The same scenario applies to our more mundane examples. Do you want to ensure financial security or career advancement? Are you more worried about ensuring you avoid making a purchase you cannot afford (if the bonus doesn't come in), or ensuring you buy that big-ticket item?
In either case, there is a trade-off. No matter what option you pick, some things become more certain, while other things less so. Some options are gained, while others are lost. Nevertheless, by looking at those options from multiple perspectives, you can make a better choice that helps ensure the likelihood of the things that are most important and satisfying to you.
© 2018 by Jeremy S. Nicholson, M.A., M.S.W., Ph.D. All rights reserved.
Barberis, N. C. (2013). Thirty years of prospect theory in economics: A review and assessment. Journal of Economic Perspectives, 27(1), 173-196.
Kahneman, D. (2003). A perspective on judgment and choice: mapping bounded rationality. American Psychologist, 58(9), 697-720.
Kahneman, D., & Tversky, A. (1979). Prospect Theory: An Analysis of Decision under Risk. Econometrica, 47(2), 263-292.
Tversky, A., & Kahneman, D. (1981). The framing of decisions and the psychology of choice. Science, 211(4481), 453-458.