Prospect Theory

Prospect Theory is a fascinating psychological and economic theory that won Daniel Kahneman his Nobel prize. For anyone who’s read my blogs, he doesn’t need any introduction; he’s been mentioned in posts time and again. Moving on, Prospect Theory suggests that human decision-making is often irrational and influenced by biases—especially when it comes to gains and losses.

The experiment is split into two parts. The first part had two groups. Group A were given two choices: guaranteed $500 or a 50% chance of winning $1000 but also 50% chance of winning nothing. They found out that the majority of people chose the former. However, when you change that into a loss – guaranteed $500 loss or 50% chance of $1000 loss and 50% chance of losing nothing – people chose the latter. This confirmed that people did not treat gains and losses equally.

Now, there’s four core components of prospect theory: Loss Aversion, Diminishing Sensitivity, Reference Dependence, and risk seeking/avoiding based on circumstance.

The last one was the one I explained in the experiment. Loss aversion was explained in the post yesterday (if you haven’t read it yet, check it out). I’ll explain the other two tomorrow. Bye for now.