Prospect Theory

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