In 1979, Daniel Kahneman and Amos Tversky introduced Prospect Theory in their paper “Prospect Theory: An Analysis of Decision Under Risk.” This groundbreaking theory challenged traditional economic models, which assumed that people make rational decisions to maximize utility. Instead, Kahneman and Tversky found that people often make irrational choices when faced with risk and uncertainty.
Key points of Prospect Theory:
- Loss Aversion: People fear losses more than they value gains of the same size, meaning they prefer avoiding losses over acquiring equivalent gains.
Imagine you’re offered two options:
A: Win $100.
B: Lose $100.
According to Prospect Theory, losing $100 feels worse than the joy of gaining $100, even though the amounts are the same. This explains why people often avoid risks that involve losses, even when the potential gain is equal. - Reference Points: Individuals evaluate outcomes based on a reference point (often their current state), rather than absolute outcomes.
Suppose you bought a stock at $100, and now it’s worth $90. You feel bad because your reference point is $100. But someone else who bought the same stock at $80 and now sees it at $90 feels happy because their reference point is lower.
Both have the same $90 stock, but how they feel depends on their individual starting points. - Diminishing Sensitivity: People are less sensitive to changes in outcomes the further they are from the reference point. For example, the difference between gaining $10 vs. $20 feels more significant than between $110 vs. $120.
If you find $10 in your pocket, you might feel excited. But if you already had $1,000 and found another $10, it wouldn’t make much difference to you. The larger your existing amount, the less impact a small gain has on your happiness.
This shows how people’s sensitivity to gains or losses decreases the further they are from the starting point.
Their research highlighted how cognitive biases influence decision-making, reshaping fields like economics, psychology, and behavioral science.
