﻿ ﻿Kahneman & Tversky’s prospect theory - Decision Making & Emotions

Kahneman & Tversky’s prospect theoryDecision Making & Emotions

There is a rational way to do calculations that involve risks. If you have a choice between a 100 per cent chance of losing \$15 and a 5 per cent chance of losing \$400, you could multiply 15 by 1.00 and 400 by 0.05 and select the choice with the lowest result. This is known as calculating ’expected utility’. However, you probably don’t use this method — when asked to make choices involving risks you probably use intuition. Daniel Kahneman and Amos Tversky developed prospect theory to describe such intuitions. A key aspect of their theory is that we think about risks of losing differently from the way we consider risks of winning. In the example above, the second choice has the lower expected utility (\$400 x 0.05 = \$20, in other words an ’expected’ loss of \$20, compared with \$15 in the first choice) — but many people feel intuitively that they would prefer the second choice. Prospect theory describes this as being ’risk seeking for losses’. You will gamble on a big loss to avoid a dead cert small loss. The reverse is where you prefer a small certain gain to a gamble over a potentially much larger gain. Prospect theory describes this as being ’risk averse for gains’.

3-SECOND PSYCHE

Our calculations involving risk are biased depending on whether we stand to gain or lose.

3-MINUTE ANALYSIS

Prospect theory was part of the work that won Daniel Kahneman a Nobel Prize in Economics, and is foundational to the area known as ’behavioural economics’, which seeks to uncover descriptions of the way we actually behave in defiance of supposedly rational behaviour. Because any gamble can result in a loss or a gain depending on what you assume the status quo is, an important consequence of prospect theory is that you can change how people feel about a bet by changing whether you describe it as a chance of a loss or a gain.

RELATED THEORIES

THE COGNITIVE REVOLUTION

DAMASIO’S EMOTIONAL DECISION MAKING

WASON’S CONFIRMATION BIAS

3-SECOND BIOGRAPHIES

DANIEL KAHNEMAN

1934—

AMOS TVERSKY

1937—1996

30-SECOND TEXT

Tom Stafford

Losses pack about twice the emotional punch of gains of the same size.

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