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

Therefore, our decision-making under risk and uncertainty follows a four-fold pattern. We tend to overestimate the likelihood of events with small probabilities and underestimate the likelihood of events with large probabilities. This leads to the following tendencies:

1. High-probability gains: Risk aversion (People prefer a sure gain over a gamble of slightly more).
2. High-probability losses: Risk-seeking (People take risks to avoid a large, certain loss).
3. Low-probability gains: Risk-seeking (People overestimate the chance of rare gains, leading to gambling).
4. Low-probability losses: Risk aversion (People overestimate the chance of rare disasters, leading to excessive insurance buying).¹⁰ 

Expected Utility Theory: A traditional economics theory that suggests that when individuals make a choice under uncertainty, they will choose the option with the highest expected utility (potential benefits).

Loss Aversion: A cognitive bias that suggests that because the psychological pain of losing is twice as powerful as the pleasure of gaining, people tend to try to avoid loss rather than trying to acquire equivalent gains.

Framing Effect: The fact that our decisions are influenced by how options are presented to us. If the presentation emphasizes a potential gain over a potential loss, people are more likely to choose that option.

Probability weighting function: A concept that describes how individuals perceive and distort probabilities when making decisions, often overestimating small probabilities and underestimating large probabilities. 

Gain Frame: A communication approach that emphasizes the positive outcomes or benefits of a choice or action.

Loss Frame: A communication approach highlighting the negative consequences or costs of not taking a particular action. 

Reference Point: The relative utility that individuals consider when evaluating potential losses or gains instead of evaluating the options according to one’s overall wealth.

Until recently, classical economics was the prominent mode of modeling human behavior. Traditional economics based its theories and models on the concept of humans as homo economicus: beings who behave perfectly rationally, therefore, make decisions which maximize utility. Utility maximization suggests people will make decisions that benefit them the most economically. Acting in a way that maximizes utility is known as expected utility theory. When it comes to evaluating losses and gains, traditional economics would predict that the level of happiness one feels when gaining $10 would be equal to the level of sadness when losing $10 because losses and gains are valued equally.

However, some economists in the late 1970s began to see the limitations of traditional economics. While it may accurately describe the way people should behave, it does not accurately predict how people actually behave. Mathematical psychologist Amos Tversky and his colleague Daniel Kahneman started to look at things differently and helped establish the field of behavioral economics. Behavioral economics does not focus solely on utility but instead incorporates factors like emotions and cognitive biases that cause individuals to deviate from purely rational decisions.

Behavioral economics challenges the expected utility theory and shows that people do not actually value all money in the same way. Whether money is being gained or lost matters to how people perceive its value. Tversky and Kahneman outlined this phenomenon, which they coined ‘prospect theory’ in their 1979 paper, ‘Prospect Theory: An Analysis of Decision Under Risk.’³

Tversky and Kahneman characterized “decisions under risk” as scenarios where individuals choose between prospects/gambles. While the expected utility theory suggests that people should approach these scenarios only concerning their probability, regardless of whether one can win or lose, Tversky and Kahneman’s experiments demonstrated ways that people did not behave according to the expected utility theory. Due to the zero risk bias, people tend to underweigh outcomes that are merely probable in favor of outcomes that are certain, and because of loss aversion, people tend to avoid risk, sometimes at the expense of potentially gaining more money.³ In behavioral economics, this pattern is known as the probability weighting function and describes how people perceive and weigh probabilities when making decisions under uncertainty. The function typically has an S-shape: it curves upward for low probabilities and flattens for higher ones. 

From their observations, Tversky and Kahneman developed prospect theory, which describes how people make decisions under risk in two phases: an editing phase and an evaluation phase. 

In the editing phase, people simplify complex choices, categorize outcomes as gains or losses relative to a reference point, and sometimes eliminate options that seem clearly inferior. For example, if a cancer patient must choose between surgery and chemotherapy, they first compare these options based on their expected survival rates rather than analyzing every detail upfront. In the evaluation phase, people assess the remaining options, but not in a purely rational way—they weigh potential gains and losses differently, often overestimating small probabilities and underestimating large ones. 

Importantly, gains and losses are defined relative to a reference point rather than absolute benefits. This means that the same outcome can feel like a gain or a loss depending on how it is framed—for example, a salary increase may feel disappointing if compared to a colleague’s higher raise, even if it objectively improves one’s financial situation.⁴

Tversky and Kahneman continued to develop their model and published a paper in 1992, ‘Advances in Prospect Theory: Cumulative Representation of Uncertainty,’ which extended the theory and concretized the concept of loss aversion.

Prospect theory is now regarded as one of the most influential frameworks in behavioral science and behavioral Economics. In 2002, Kahneman was awarded the Nobel Prize in Economics for the contributions that prospect theory made to behavioral economics.

Daniel Kahneman

Israeli-American psychologist best known for his work on behavioral economics (earning him the title of ‘grandfather of behavioral economics’) and the psychology of judgment and decision-making. During his illustrious career, Kahneman held positions at a range of universities in the United States and Israel and summarized much of his research in his book Thinking, Fast and Slow (2011). 

Amos Tversky

Israeli cognitive and mathematical psychologist who played a pivotal role in the discovery of systematic human cognitive bias and the handling of risk. Like Kahneman, Tversky was also a pioneer in the field of behavioral economics and is particularly known for his work on heuristics and loss aversion. 

Prospect theory is important because it explains how we understand and value gains and losses differently and, therefore, how we approach choices under risk. Prospect theory has been used to study decision-making across various fields, including economics and finance, international relations, and marketing. In the context of international relations and foreign policy, decision-makers who are confronted with crippling losses are more likely to take risky decisions around peace deals, disarmament, or lowering economic barriers than those who are happy with how things are.¹² 

Prospect theory can also help us understand how best to present options to others. A financial advisor, for example, would want to market her mutual fund pitch to a potential client in a way that highlights its potential gains. Imagine the same mutual fund is presented in these two different ways:

1. The mutual fund had an average return of 11% over the past two years.
2. The mutual fund had above-average returns in the past ten years, but in the past year, it has been declining.

Although the mutual fund is the same in both instances, prospect theory predicts that we’d be more likely to invest if it was marketed to us in Form A since this form markets it as an overall gain instead of a series of gains and losses.⁵ 

Prospect theory also plays a role in gambling. Even though we tend to avoid loss and prefer certain outcomes, an individual is more likely to continue gambling after losing money in an effort to make back the money they lost. An individual who has lost $200 playing blackjack is more likely to take a risk again to try and make up that $200 and not face an overall loss compared to a player who has won $50. The player who has won money—even though less—is less likely to play again for fear of losing it.²

Prospect theory and helping others 

But how does prospect theory work if we have to make decisions for other people? Perhaps you need to help your college-aged student make financial decisions around student loans or support an elderly parent with their pension management. When making interpersonal decisions, i.e. decisions for other people, the four-fold pattern of decision-making is actually attenuated and reversed. In other words, we weigh up losses and gains in decisions differently when they relate to other people than when they are about us. A study by Qingzhou Sun, Evan Polman, and Huanren Zhang found that when asked to make decisions about other people’s finances, participants took more risks for others when the situation involved potential gains but took fewer risks for others when it involved potential losses.¹⁰ 

Is prospect theory universal?

It’s also important to note that prospect theory may look different depending on which culture you’re examining. In a pair of studies conducted by Roger Marshall et al., Singaporeans and Chinese were found to be less risk averse compared to people from the Netherlands and New Zealand in both a gain frame and a loss frame (i.e. when a decision is presented with potential gains or losses, respectively) when making a personal financial decision.¹¹ The same pattern was found when individuals need to make a decision to switch suppliers in a business relationship: Asian participants were more likely to be risk averse even when the switch is framed as a risk decision.  

Prospect theory has been well received, as demonstrated by Kahneman’s Nobel Prize in Economics, awarded for the model’s contributions to the field. It seems to demonstrate how people actually behave instead of how they should behave, which many would consider a more useful model for predicting behavior.

However, while the theory acknowledges that people make decisions based on perceived gains and losses (with special attention to avoiding losses), it does not comprehensively explain why. Although loss aversion is attributed to the psychological experiences of pain and pleasure, Tversky and Kahneman did not offer up a theory as to why the psychological pain of loss is so much more powerful than the psychological pleasure of gain. Therefore, the theory doesn’t comprehensively address how emotions factor into our decisions but only claims that they do.

Prospect theory and loss aversion are also often referenced as a reason people choose to purchase insurance. People tend to overestimate rare risks (e.g., house fires) and underestimate common risks (e.g., car accidents), leading to insurance decisions that may not align with actual probabilities. This probability distortion explains why people often overpay for coverage against rare disasters while underinsuring against more frequent events. 

Prospect Theory and Relocating

If you’ve ever had to move to a new house or apartment, you know how daunting the task can be. Moving takes time and money and means that you have to leave your current home behind. Since it is a high-stress situation that involves a lot of uncertainty, prospect theory might be useful in explaining why people choose to stay or relocate.

In their 2017 study, William Clark and William Lisowski suggest that the riskier a move seems (the further from one’s local community, for example), the less likely someone is to move. They attribute this to prospect theory and the endowment effect, which describes the tendency to value things we already own (like houses) more than we would if they didn’t already belong to us.⁸

Another study conducted by Jinhai Yan and Helen Bao looked at the relationship between prospect theory and housing satisfaction after relocation.⁹ Within the context of urbanization development in the city of Xiamen, Yan and Bao investigated two important elements of prospect theory, reference point dependence and loss aversion, in relation to the satisfaction levels of residents who had recently been displaced and forced to relocate as a result of new housing developments. The results of the study show that displaced households use both internal and external reference points (i.e. their experience with their old home and comparisons with the living conditions of others, respectively) to determine their level of satisfaction with their home. Moreover, similar to Clark and Lisowski’s study, losses were found to matter more than gains in relocation outcomes, indicating the presence of the endowment effect and its impact on satisfaction with a new home. 

Calculating Gains and Losses as a Customer

Imagine the scenario: you see your dream clothing item reduced to 50% in a Black Friday sale. You head to the store’s website later that day only to find that they’re out of your size. A month later, you see the same item with a 30% discount and decide to buy it. However, you find it difficult to enjoy the new clothing because you can’t stop thinking about the 20% discount you ‘lost.’

Prospect theory explains a lot about how we shop and make purchasing decisions. As the example above suggests, we tend to feel more the pain and disappointment of losing an amazing discount than the joy of gaining another one. Businesses understand that we value gains and losses differently and can use this as a way of nudging us into buying something or signing up for a service. Online hotel and flight booking sites such as Booking.com or Agoda often use phrases like ‘Only 3 rooms left’ or ‘1 seat left at this price’ to emphasize apparent scarcity and loss aversion. 

The way companies and service providers frame and describe their products and offerings can also have a huge impact on our decision to make a purchase. For example, healthcare providers may frame their preventative care services as avoiding potential health losses rather than simply gaining good health. By making potential customers aware of the risks of certain conditions and what people stand to lose if they don’t take preventative action, companies can tap into people’s fear of losing their good quality of life. In other words, individuals mentally compare their current situation with what might be if they were to fall ill with a preventative illness. If the company’s preventative care services were framed in a way that highlighted gains, for example, ‘gaining a healthier future,’ individuals may feel less strongly inclined to enroll in the healthcare scheme because we value gains less than potential losses. Likewise, insurance companies often capitalize on our tendency to overweigh unlikely but costly events to persuade us to purchase coverage plans. 

To Vote Or Not To Vote?

To get an insight into how prospect theory influences not only our economic decisions, but our political ones, check out this article by Pooja Salhotra. Salhotra highlights the importance of framing in influencing voter turnout.

Learning Within Limits: How Curated Content Affects Education 

Offering trigger warnings before exposing someone to potentially distressing content has become commonplace. In this article, Katharine Sephton analyzes the value and effectiveness of these warnings. She suggests that trigger warnings make use of prospect theory, as they cause an individual to evaluate whether, based on the warning, they will experience a psychological gain (ie. knowledge) or a psychological loss (ie. distress).

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12. McDermott, R. (2001). Risk-Taking in International Development: Prospect Theory in American Foreign Policy. University of Michigan Press.