What is prospect theory?
Prospect theory was introduced in 1979 by psychologists Daniel Kahneman and Amos Tversky. Classical economics assumed people choose by calculating expected utility. Prospect theory showed instead that people evaluate outcomes as gains and losses relative to a reference point, and they especially dislike losses. Kahneman received the 2002 Nobel Memorial Prize in Economic Sciences for this work.
- Researchers
- Daniel Kahneman, Amos Tversky
- Published
- 1979, Econometrica
- Core ideas
- Reference dependence, loss aversion, probability weighting
- Impact
- Foundation of behavioral economics; 2002 Nobel Prize
The three core principles
| Principle | Meaning | Example |
|---|---|---|
| Reference dependence | We feel changes from a reference point, not absolute amounts | A $70,000 salary feels like a loss if your peers make $80,000 |
| Loss aversion | Losses weigh more than equal gains | Losing $50 hurts more than finding $50 pleases |
| Diminishing sensitivity | Differences matter less as amounts grow | $10 vs. $20 feels bigger than $1,010 vs. $1,020 |
The value function is concave and gentle for gains, convex and steeper for losses. That is why people tend to take the sure thing when facing gains (risk-averse) but gamble when facing losses (risk-seeking).
How much more do losses hurt?
Losses are often said to feel about twice as powerful as gains. Based on a range of experiments, Tversky and Kahneman (1991) estimated that losses are weighted roughly twice as heavily as equivalent gains, which is why many people will accept a coin flip that risks losing $100 only if they could win around $200.
The endowment effect
In an experiment by Kahneman, Knetsch and Thaler (1990), students given a coffee mug demanded about twice as much to sell it as other students were willing to pay. Once something is yours, giving it up feels like a loss. This is the endowment effect.
Prospect theory in everyday life
- Investing: People sell winners too early and hold losers hoping to "get back to even," a pattern called the disposition effect.
- Marketing: "Don’t miss out" messages framed as losses often outperform gain-framed ones.
- Free trials: Canceling after a trial feels like losing something, so subscriptions continue.
- Sticking with bad choices: Refusing to quit because of money already spent relates to the sunk cost fallacy; the first price you see becoming a reference point is the anchoring effect.
Keeping loss aversion in check
- Reset the reference point. Ask, "If I didn’t own this stock, would I buy it today?"
- Think in portfolios. Checking individual investments often makes you feel losses more often.
- Notice framing. Ask whether a message is framed as a gain or a loss.
Frequently asked questions
- What is prospect theory?
- Kahneman and Tversky’s theory that people evaluate risky choices as gains and losses from a reference point and feel losses more strongly than gains.
- What is loss aversion?
- The tendency for losses to feel larger than gains of the same size, estimated in studies at roughly twice as large.
- What is the endowment effect?
- The tendency to value something more once you own it, so sellers ask much more than buyers are willing to pay.
References
- Kahneman, D., & Tversky, A. (1979). Prospect theory: An analysis of decision under risk. Econometrica, 47(2), 263–291.
- Tversky, A., & Kahneman, D. (1991). Loss aversion in riskless choice: A reference-dependent model. Quarterly Journal of Economics, 106(4), 1039–1061.
- Kahneman, D., Knetsch, J. L., & Thaler, R. H. (1990). Experimental tests of the endowment effect and the Coase theorem. Journal of Political Economy, 98(6), 1325–1348.