When I was in grad school, I really enjoyed reading and studying theory and finding how it played out in the world around me. Good theory comes to life everywhere, if you look closely enough.
For example, when I see people — usually politicians — who are perfectly comfortable with their own hypocrisy — but, ironically, not that of others — I see cognitive dissonance theory at work. When I see unintended consequences take place, I suspect it’s because of the effects of uses and gratifications theory.
Lately I’ve been reading an engaging book my wife bought for me called, “Misbehaving: The Making of Behavioral Economics.” Written by Dr. Richard H. Thaler, the book is not as dry and impenetrable as the title might have you believe. I wouldn’t call it light reading, but it’s a fun and hugely interesting book.
The book — and at least part of the field of behavioral economics, for that matter — centers on prospect theory, which is “a behavioral model that shows how people decide between alternatives that involve risk and uncertainty,” specifically regarding the likelihood of gains or losses, according to BehavioralEconomics.com. The theory shows that people think in terms of “expected utility relative to a reference point rather than absolute outcomes.” In economics, that reference point is typically an entity’s current wealth.
First outlined by professors Dan Kahneman and Amos Tversky, prospect theory holds that people are loss averse. We dislike losses to a greater degree than we like equivalent gains, and we are more willing to take risks to avoid those losses.
Prospect theory has wide applicability. It has been used in such diverse fields as consumer choice, labor supply, management and insurance. It also has been used to model people’s behavior when investing and gambling.
For example, according to Thaler, mutual fund managers have a tendency to take on greater risk in the last quarter if the fund they are managing is trailing a benchmark index. Similarly, bettors who are “down” at a horse track begin to bet on longshot horses to try to break even. According to Thaler, “more people are betting on the horses least likely to win.”
Which brings us to the racetrack we are more familiar with. Think about the races you’ve been involved in. When do drivers take more risks? Which drivers take them, and why?
If the theory holds true in automobile racing — and I’m betting it does — drivers who take more risks are usually in the same position as bettors who are “down” at the horse track. A driver who has lost positions since the start of a race likely would be more willing to take more risk than a driver who has not lost any spots since the start, or gained positions. A driver’s starting position is equivalent to the “reference point” outlined in prospect theory. The risk-taking likely would play out more noticeably toward the end of a race, and it should hold true regardless of whether we’re talking about a podium finisher or somewhere midpack.
Prospect theory manifests itself in racing in the form of low-percentage pass attempts and other risky moves the same drivers wouldn’t have attempted earlier in the race, or if they hadn’t lost positions since the start.
“A good rule to remember,” said Thaler, “is that people who are threatened with big losses and have a chance to break even will be unusually willing to take risks, even if they are normally quite risk averse.”
If you haven’t witnessed drivers demonstrating prospect theory, it might be because you weren’t aware of it. However, now that you know a little more about it, tuck it in the back of your mind and see if you can spot it in future races — or see it in yourself. Good theory comes to life everywhere, if you look closely enough.