Prospect Theory

What is Prospect Theory?

Developed by Daniel Kahneman and Amos Tversky, Prospect Theory explains how people make decisions when they face risk or uncertainty. Unlike traditional economics, which assumes people are rational and always aim to maximize utility, Prospect Theory shows that people value gains and losses differently, leading to irrational decisions.

Key Concepts of Prospect Theory

The Value Function
- 📈 Gains vs. Losses
  - People are risk-averse when it comes to gains and risk-seeking when it comes to losses.
  - Example: Given the choice between a sure $100 gain or a gamble for $200 with a 50% chance, most people choose the sure gain. But if faced with a sure loss of $100 or a gamble with a 50% chance to lose $200, people often take the gamble.

Loss Aversion
- ❗ People hate losing more than they enjoy winning.
- Example: Losing $100 feels worse than gaining $100 feels good. This leads to irrational choices, like holding onto failing investments to avoid losses.

Reference Points
- 🔄 Decisions are influenced by where you start from, not just the final outcome.
- Example: Someone who’s lost $500 may feel very differently about gaining $100 compared to someone who’s already gained $500.

How Does Prospect Theory Work?

Step 1: You evaluate the potential gains and losses.
- 💰 For Gains: People tend to avoid risks.
- 🔻 For Losses: People take risks to avoid certain loss.

Step 2: You assess based on a reference point.
- 🚦 You may evaluate outcomes based on where you are now rather than the absolute outcome.

Step 3: Loss aversion kicks in, and you react more strongly to potential losses than to potential gains.

Loss Aversion
- 📉 Losses feel worse than gains of the same amount.

Risk Aversion for Gains
- 💰 People prefer certainty in gains.

Risk-Seeking for Losses
- 🔻 People take more risks to avoid losses.