Prospect theory is a descriptive model of decision-making under risk, proposed by the psychologists Daniel Kahneman and Amos Tversky in "Prospect Theory: An Analysis of Decision under Risk," published in Econometrica in 1979. It replaced the standard economic assumption that people maximize expected utility over their final wealth with an account of what people actually do: they code outcomes as gains and losses relative to a reference point, they weight a loss more heavily than an equal gain, and they respond to probabilities in a distorted, nonlinear way. It is "descriptive" rather than "normative," meaning it tries to predict real choices rather than prescribe rational ones.
Prospect Theory
Prospect theory is the model of how people actually decide under risk: they judge outcomes as gains and losses from a reference point rather than as final wealth, feel losses more sharply than equivalent gains, and misweight probabilities.
Last reviewed by Steven Fox, CFP®, EA
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Quick Summary
- Prospect theory was set out by Daniel Kahneman and Amos Tversky in a 1979 paper in the journal Econometrica; it later anchored Kahneman's 2002 Nobel prize in economics.
- Its core claim, reference dependence, is that people evaluate an outcome by how it compares to a starting point, not by their total wealth afterward.
- The value it places on outcomes is S-shaped, so a gain and a loss of the same size do not cancel out, and a loss looms larger.
- People also distort probabilities, overweighting rare events and underweighting near-certain ones, which is why the same person can buy both insurance and lottery tickets.
- Loss aversion is one component of prospect theory, not the whole of it.
Definition
Advanced Explanation
Three findings do the work in prospect theory, and it is worth keeping them separate because they are often collapsed into the single phrase "loss aversion."
The first is reference dependence. Standard theory says a person with $1,010,000 is better off than one with $1,000,000 and should choose accordingly, full stop. Prospect theory says people do not evaluate final states at all; they evaluate changes. Whether $1,010,000 registers as a gain or a loss depends entirely on the reference point it is measured against, and that point is usually the status quo or an expectation, which is why the same outcome can feel like a win or a disappointment depending on what was anticipated.
The second is the shape of the value function. It is concave for gains (each additional dollar of gain adds less satisfaction than the last) and convex for losses (each additional dollar of loss stings less than the last), and it is steeper on the loss side. The steepness is loss aversion, the specific finding that a loss hurts more than an equal gain pleases. The curvature produces the reflection effect: people tend to be risk-averse when choosing among gains and risk-seeking when choosing among losses, taking a sure gain but gambling to avoid a sure loss.
The third is probability weighting. People do not treat a probability at face value. They overweight small probabilities and underweight moderate to high ones, which explains a pattern expected-utility theory cannot: the same person buying insurance against a rare disaster and a lottery ticket against long odds. A 1992 revision by the same authors, cumulative prospect theory, refined this weighting and extended the model to outcomes with many possible values.
Prospect theory is the parent framework; several behavioral-finance patterns are its consequences. The disposition effect, selling winners too early and holding losers too long, follows from the reflection effect. Mental accounting interacts with reference points, because how a choice is framed sets the reference against which its outcomes are judged.
How to Remember
People do not think about how much they have; they think about what they are up or down, and being down hurts worse than being up feels good.
Used in a Sentence
“Prospect theory predicts that Renee will hold a stock she is down on far longer than one she is up on, because closing the losing position forces her to convert a paper loss into a felt one.”
How It Works
The value function assigns satisfaction to a change from a reference point, and its two halves behave differently.
A hypothetical illustration of the reflection effect. Offer someone a choice between receiving a sure $500 and a coin flip for $1,000 or nothing. Most people take the sure $500, even though the two options have the same expected value; in the domain of gains they are risk-averse. Now offer the mirror image: a sure loss of $500, or a coin flip that loses $1,000 or nothing. Most of the same people now take the gamble, preferring a chance to avoid the loss entirely over accepting a certain one; in the domain of losses they turn risk-seeking. Standard theory says a consistent person should treat these two problems the same way. Prospect theory predicts the switch, and experiments find it.
The practical reading is not that this behavior is stupid. It is that a choice can be steered by how it is framed relative to a reference point, so the same decision described as "keep $500" or "avoid losing $500" can draw opposite answers from the same person.
Pros and Cons
Strengths as a model
- It predicts real choices that expected-utility theory gets wrong, including insurance-plus-lottery behavior and the reflection effect.
- It is grounded in controlled experiments rather than assumption, and the core patterns have replicated widely.
- It explains a family of downstream behaviors (the disposition effect, framing effects, the endowment effect) from a small set of principles.
Limits
- It is descriptive, not prescriptive: it says what people do, not what they should do, and using it as a guide to good decisions inverts its purpose.
- Reference points are not fixed or always obvious, which can make the model hard to apply to a specific real choice in advance.
- Effect sizes and the exact probability-weighting curve vary across studies and populations, so it is a robust pattern rather than a precise formula.
People Also Asked
Answers to the most frequently asked questions.
What is the difference between prospect theory and loss aversion?
Loss aversion is one piece of prospect theory, not a synonym for it. Loss aversion is the specific finding that a loss hurts more than an equal gain feels good. Prospect theory is the larger model that contains loss aversion alongside reference dependence and probability weighting. Every discussion of loss aversion is drawing on prospect theory, but the full theory says more than loss aversion alone.
Who created prospect theory and when?
Daniel Kahneman and Amos Tversky introduced it in a 1979 paper in the economics journal Econometrica. Kahneman received the 2002 Nobel Memorial Prize in Economic Sciences for the body of work it anchored; Tversky had died in 1996 and the prize is not awarded posthumously. The two extended the model in 1992 as cumulative prospect theory.
Why does prospect theory say people buy both insurance and lottery tickets?
Because people overweight small probabilities. A rare catastrophe and a rare jackpot both feel more likely than their true odds, so paying a little to avoid the first and paying a little for a shot at the second can both feel worth it to the same person. Expected-utility theory, which takes probabilities at face value, cannot easily produce that pattern.
Is prospect theory the same as expected utility theory?
No. Expected utility theory, the older standard model, assumes people evaluate the final wealth each option would leave them with and weight outcomes by their true probabilities. Prospect theory says people evaluate gains and losses from a reference point instead, treat losses as more painful than equal gains, and distort probabilities. It was built specifically to describe the choices expected utility theory predicts incorrectly.
Sources
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