Prospect Theory
What is Prospect Theory?
Prospect theory explains that individuals prefer avoiding losses over acquiring equivalent gains, favor options with more certain outcomes due to natural risk aversion, and evaluate choices based on relative differences rather than absolute similarities. This often leads to choosing certain gains over potentially larger but riskier ones.
The Basic Idea
In the game of Monopoly, chance cards either give a player an advantage or a consequence. For example, they may reveal that a player has won $100, or force a player to pay the bank the same amount.
Imagine you are playing Monopoly and pick one of each of these cards throughout the game. How do you think you’d feel if you gained $100? How do you think you’d feel if you lost $100? Would it matter how much money you had already?
According to Daniel Kahneman and Amos Tversky’s famous prospect theory, we value losses and gains disproportionately. We are more likely to feel worse about losing $100 than we are to feel better about gaining $100, regardless of our absolute wealth. This is because prospect theory suggests we evaluate outcomes based on their relative utility rather than their absolute utility.
Due to our disproportionate perspectives on losses and gains, prospect theory stipulates that we would prefer to avoid a potential loss than risk a potential gain. Since we are naturally risk averse, the theory also suggests that we tend to choose options with more certain outcomes. Lastly, because we evaluate outcomes relatively, we tend to focus on the differences between our options rather than the similarities.2
Gains and losses are short-term. They’re immediate, emotional reactions. This makes an enormous difference to the quality of decisions.
– Daniel Kahneman, in an interview part of a series on Nobel Laureates in Economics, conducted by the UBS investment banking company.1
About the Authors
Dan Pilat
Dan is a Co-Founder and Managing Director at The Decision Lab. He is a bestselling author of Intention - a book he wrote with Wiley on the mindful application of behavioral science in organizations. Dan has a background in organizational decision making, with a BComm in Decision & Information Systems from McGill University. He has worked on enterprise-level behavioral architecture at TD Securities and BMO Capital Markets, where he advised management on the implementation of systems processing billions of dollars per week. Driven by an appetite for the latest in technology, Dan created a course on business intelligence and lectured at McGill University, and has applied behavioral science to topics such as augmented and virtual reality.
Dr. Sekoul Krastev
Sekoul is a Co-Founder and Managing Director at The Decision Lab. He is a bestselling author of Intention - a book he wrote with Wiley on the mindful application of behavioral science in organizations. A decision scientist with a PhD in Decision Neuroscience from McGill University, Sekoul's work has been featured in peer-reviewed journals and has been presented at conferences around the world. Sekoul previously advised management on innovation and engagement strategy at The Boston Consulting Group as well as on online media strategy at Google. He has a deep interest in the applications of behavioral science to new technology and has published on these topics in places such as the Huffington Post and Strategy & Business.
