Prospect Theory
What is Prospect Theory?
Prospect theory describes how individuals make decisions under uncertainty, emphasizing that people tend to prioritize avoiding losses over acquiring equivalent gains (loss aversion). However, their risk preferences shift based on the framing of choices—people are risk-averse when faced with gains but risk-seeking when facing losses
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
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:
- High-probability gains: Risk aversion (People prefer a sure gain over a gamble of slightly more).
- High-probability losses: Risk-seeking (People take risks to avoid a large, certain loss).
- Low-probability gains: Risk-seeking (People overestimate the chance of rare gains, leading to gambling).
- Low-probability losses: Risk aversion (People overestimate the chance of rare disasters, leading to excessive insurance buying).10
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
Dr. Sekoul Krastev is a decision scientist and Co-Founder of The Decision Lab, one of the world's leading behavioral science consultancies. His team works with large organizations—Fortune 500 companies, governments, foundations and supernationals—to apply behavioral science and decision theory for social good. He holds a PhD in neuroscience from McGill University and is currently a visiting scholar at NYU. His work has been featured in academic journals as well as in The New York Times, Forbes, and Bloomberg. He is also the author of Intention (Wiley, 2024), a bestselling book on the science of human agency. Before founding The Decision Lab, he worked at the Boston Consulting Group and Google.
