Prospect Theory or Skill Signaling
39 Pages Posted: 28 May 2002
Date Written: August 2006
Failure is embarrassing. In gambles involving both skill and chance, we show that a strategic desire to avoid appearing unskilled generates behavioral anomalies that are typically explained by prospect theory's concepts of loss aversion, probability weighting, and framing effects. Loss aversion arises because losing any gamble, even a friendly bet with little or no money at stake, reflects poorly on the decision maker's skill. Probability weighting emerges because winning a gamble with a low probability of success is a strong signal of skill, while losing a gamble with a high probability of success is a strong signal of incompetence. Framing matters when there are multiple equilibria and the framing of a gamble affects beliefs, e.g., when someone takes a "dare" rather than admit a lack of skill. The analysis is based on models from the career concerns literature and is closely related to early social psychology models of risk taking. The results provide an alternative perspective on the existence of prospect theory behavior in managerial and financial decisions where both skill and chance are important. We identify specific situations where skill signaling makes opposite predictions than prospect theory, allowing for tests between the strategic and behavioral approaches to understanding risk.
Keywords: prospect theory, regret theory, probability weighting, loss aversion, framing
JEL Classification: D81, D82, C92, G11
Suggested Citation: Suggested Citation