A fun topic is Prospect Theory. It seems logical that people would make decisions to maximize utility. However, people behave irrationally. Here are the basics:
1. Prospect Theory was presented by Kahneman and Tversky in ’79.
2. The theory is a behavioral model that guides decisions involving risk and uncertainty.
3. People value losses and gains differently from each other.
4. The theory suggests that losses hit us harder. There is a greater emotional impact with a loss.
5. If a person is shown two choices, presented differently (one showing gains and the other losses), the person is more likely to be risk-averse when seeking gains, and risk-taking when avoiding losses.
An example:
Scenario 1
A: 95% chance of winning $10,000.
B: 100% chance of winning $9,499.
Scenario 2
A: 95% chance of losing $10,000.
B: 100% chance of losing $9,499.
You were likely to have picked B in Scenario 1, and A in Scenario 2, despite A in 1 and B in 2 being probabilistically favorable.
This contradiction in human behavior is Prospect Theory at work.
Loss creates a greater feeling of pain relative to the joy created by a similar gain.
Equipped with this awareness around framing risk, I challenge you to think of events in terms of outcomes vs. reference points (think: insurance, stocks, deals).
