No. 52 · Risk · Economics
Prospect Theory
Losses hurt about twice as much as equal gains please, and that bends our choices.
In the Almanac
“Barings Bank”, 1995 · “JCPenney”, 2012
Both stories in full, three ways to use it and where it misleads.
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Questions
What is Prospect Theory?
Prospect Theory, from Daniel Kahneman and Amos Tversky, explains how we really make risky choices. We judge outcomes as gains or losses from a reference point, feel losses more sharply than equal gains, and take reckless risks to escape a loss.
How do you use Prospect Theory?
Use it by reframing decisions both ways to see if your preference flips, resisting the urge to break even on a losing bet, and harnessing loss aversion to keep good habits on track.
When does Prospect Theory matter?
Prospect Theory is one of the 32 mental models for risk, the situations where you ask: What could go wrong, and what will I do if it does? Within that, it belongs to “Misreading chance”, alongside Availability Bias, Conjunction Fallacy and Gambler’s Fallacy.
What is an example of Prospect Theory?
Two stories show it at work: Barings Bank (1995) and JCPenney (2012). Both are told in full in The Mental Models Daily Almanac, which has two stories for each of its 365 models.
Which mental models are related to Prospect Theory?
Loss Aversion, Framing and Sunk Cost Fallacy. Prospect Theory itself comes from economics.