Reference Point
The Basic Idea
Famed psychologists Daniel Kahneman and Amos Tversky are best known for developing prospect theory, a key contribution to the field of economics. Prospect theory, which was developed over the course of thirty years of extensive research, offers an explanation for typical patterns of risk and uncertainty management.1 The concept of a reference point is a principal feature of this theory.
Prospect theory suggests that when people are presented with alternatives, each with their own probability of gains and losses, they will assess the utility – the potential benefits – of each possible outcome, relative to a reference point – for example, how much money they currently have. They are not evaluating the absolute utility of each outcome, but rather the relative utility.2 The theory of loss aversion posits that people would rather take a risk to avoid a loss than take an equivalent risk in order to gain something of equivalent value.3 We depend on reference points in order to classify the potential outcomes of different options as gains or losses.4
An example of the role of reference points in prospect theory comes from a study conducted by Idris Adjerid and their colleagues, the results of which were published in 2013 in a paper titled “Sleights of privacy: Framing, disclosures, and the limits of transparency”.5 When people are presented with online privacy notices, they compare the level of protection offered to the level of protection offered by privacy notices that had previously been presented. Say, for example, a group of people in an online study are presented with privacy notice A, and then asked to answer a series of questions, while another group of people are presented first with privacy notice B, which offers a higher level of protection than privacy notice A, and then are subsequently presented with privacy notice A and asked to answer the same questions. People in the first group will disclose more information after seeing privacy notice A than will those in the second group. This is because the people in the second group are using privacy notice B, which is more protective, as a reference point and therefore view privacy notice A as insufficient and too risky.
An investment said to have an 80% chance of success sounds far more attractive than one with a 20% chance of failure. The mind can’t easily recognize that the two are the same.
– Daniel Kahneman
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.
