Prospect Theory: An Analysis of Decision under Risk
Daniel Kahneman & Amos Tversky · 1979
"Losses and gains of the same objective size are not felt equally — losing a given amount hurts roughly twice as much as gaining the same amount feels good — which systematically distorts decisions under risk away from what a purely rational, outcome-maximizing calculation would recommend."
Prospect theory, the paper that eventually won Kahneman a Nobel Prize, replaced the classical economic assumption that people evaluate outcomes by their final wealth with a more accurate model: people evaluate outcomes as gains or losses relative to a reference point, usually the status quo, and the psychological impact of a loss is roughly twice as intense as an equally-sized gain — a ratio researchers now call the loss-aversion coefficient, typically found to cluster between 1.5 and 2.5.
This asymmetry produces predictable, seemingly irrational patterns: people become risk-averse when facing possible gains, preferring a certain smaller reward over a risky larger one, but risk-seeking when facing possible losses, preferring a risky gamble to a certain loss of the same expected value, essentially gambling to avoid definitely losing. This is why people hold onto losing investments too long, since selling would lock in the painful loss, while selling winning investments too early, locking in the pleasant but smaller gain — the exact opposite of what a rational, forward-looking strategy would recommend in most cases.
What is the core claim of loss aversion in prospect theory?
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The explanation above is written with AI assistance. These are the originals — go to them to check it.
- Prospect Theory: An Analysis of Decision under RiskThe Econometric Society
Unskilled and Unaware of It
"People with low competence in a domain tend to overestimate their own ability, because the same skills required to perform well in that domain are also the skills required to accurately judge good performance — so incompetence doubly disadvantages you: it produces poor results and simultaneously removes your ability to recognize that the results are poor."