Prospect theory, which is a behavioral model that shows how people decide between alternatives that involve risk and uncertainty (e.g. % likelihood of gains or losses), demonstrates that people think in terms of expected utility relative to a reference point (e.g. current wealth) rather than absolute outcomes. Prospect theory was developed by framing risky choices, and it indicates that people are loss-averse, and since individuals dislike losses more than an equivalent gain, they are more willing to take risks, in order to avoid a loss. Due to the biased weighting of probabilities (see certainty/possibility effects) and loss aversion, the theory leads to the following pattern in relation to risk (Kahneman & Tversky, 1979; Kahneman, 2011):

GAINSLOSSES
HIGH PROBABILITY

(Certainty Effect)
95% chance to win $10,000

Fear of disappointment

RISK-AVERSE
95% chance to lose $10,000

Hope to avoid loss

RISK-SEEKING
LOW PROBABILITY

(Possibility Effect)
5% chance to win $10,000

Hope of large gain

RISK-SEEKING
5% chance to lose $10,000

Fear of large loss

RISK-AVERSE

 

Kahneman, D. (2011). Thinking, fast and slow. London: Allen Lane.

Kahneman, D., & Tversky, A. (1979). Prospect theory: An analysis of decision under risk. Econometrica, 47, 263-291.

 

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