prospect theory

Suppose you face two choices. First: a sure 900 dollars, or a 90 percent chance at 1,000 dollars. Most people grab the sure 900 — they play it safe. Second: a sure loss of 900 dollars, or a 90 percent chance of losing 1,000. Now most people gamble, hoping to escape the loss. The same person turns cautious about gains and reckless about losses. Old theory couldn't explain that flip; prospect theory was built to.

Prospect theory, by Daniel Kahneman and Amos Tversky (1979), describes how people actually evaluate risky choices, and it rests on three ideas. First, people judge outcomes as gains or losses relative to a reference point (usually their current situation), not as final wealth levels. Second, losses hurt more than equal gains feel good — loss aversion gives the value curve a steeper slope below zero. Third, people are risk-averse when facing gains but risk-seeking when facing losses, which produces that flip above. It also says we distort probabilities: we over-weight tiny chances (why we buy lottery tickets and insurance) and under-weight near-certainties.

Prospect theory matters because it replaced 'expected utility theory' as the best description of real decisions under risk, and it earned Kahneman a Nobel Prize (Tversky had died). It explains lotteries, insurance, why investors sell winners and hold losers, and how the framing of a choice changes it. The honest caveat: prospect theory is a description of behavior, not a recipe for the smartest choice — it tells you how people do decide, not how a perfectly rational agent should. And like all such models, its exact parameters vary across people and settings.