What is Prospect Theory? Evaluating Risk and Loss Aversion

Welcome to Founder’s Framework, offering full access to objective, informational, and researched articles on core business frameworks — aggregated into a single, organized space.

This article provides a detailed overview and expert insights on the prospect theory (also known as loss aversion) to help leaders select the appropriate framework to support business growth and sustainability.

What Is Prospect Theory?

Prospect theory, also known as loss aversion, belongs to the behavioral economic subgroup and describes how people make decisions under conditions of risk and uncertainty. This theory was formulated in 1979 and further developed in 1992, leading to it becoming more psychologically accurate in terms of how decisions are made under cumulative (rather than separable) decision weights and across various outcomes.

Who Created Prospect Theory?

Prospect theory was developed by psychologists Daniel Kahneman and Amos Tversky in 1979. Their groundbreaking research on decision-making under the pressure of risk and uncertainty laid the foundation for understanding how people evaluate potential losses and gains. Since its inception, this theory has had a significant impact on behavioral economics and finance.

Kahneman and Tversky proposed that losses have a greater emotional impact on an individual than an equivalent amount of gain. So, given two choices — both offering the same result — an individual will select the option offering perceived gains.

Key Concepts of Prospect Theory

• Loss aversion: This concept asserts that losses are felt more strongly than equivalent gains. This explains why individuals are often more motivated to avoid losses than to acquire gains of equal value.
• Framing effects: This refers to how choices are “framed” and the impact that framing can have on decision-making. It highlights that decisions are not always based on pure logic or utility.
• Certainty effects: This refers to when individuals prioritize certain outcomes over probable ones. This explains behaviors such as buying insurance for unlikely events.
• Reference point dependence: People evaluate outcomes relative to a reference point (typically the status quo) rather than in absolute terms. This explains behaviors such as purchasing common, popular items rather than those that are more niche.
• Nonlinear probability weighting: People tend to place more weight on small probabilities and undervalue large probabilities. This explains behaviors such as avoiding air travel after learning of a plane crash.
• Subjective value assessment: Prospect theory recognizes that people assess value subjectively rather than purely based on objective expected utility. This allows for a more nuanced understanding of how people make decisions.

Original Source: Economics Theory

Key Pain Points Addressed

Prospect theory addresses key pain points related to stress and human performance:

Overall, the application of prospect theory helps companies align strategies (for example, pricing, marketing, and business development), financial policies, and communications with decision-making behaviors.

When You Should Apply Prospect Theory

Prospect theory is applicable across all stages of organizational development. It's particularly useful when:

Pros and Cons of Prospect Theory

As you evaluate this framework, consider the top pros and cons:

Pros

Cons

TLDR: Prospect Theory in Summary

As with any behavioral theory, prospect theory should be approached with flexibility and dedicated, long-term assessment. Regular feedback and data analysis will properly guide theory application and better ensure that it will enhance individual and organizational outcomes.

Guided Approach to Prospect Theory 

If you believe prospect theory is applicable to your organization, it’s time to start preparing for implementation. Consider the following guides as you move forward with theory application:

Ensure stakeholders have a deep understanding of the theory. 

Research the framework's core concepts, including loss aversion, framing effects, reference point, and probability weighting.

Assess current decision-making processes. 

Evaluate how risk and uncertainty are currently handled in your organization and document the results for deeper analysis among all Ideal Stakeholders.

Identify key decision points. 

Determine where prospect theory insights could be most beneficial within your organization. This can be at the individual, team, department, or company-wide levels.

Evaluate existing reframe choices. 

Consider how decisions are currently presented within your organization and explore alternative framings. Be sure to test framings for the best long-term results.

Educate all stakeholders. 

Provide training on prospect theory and its implications for decision-making across roles and departments.

Implement decision support tools. 

Develop tools that incorporate prospect theory insights to aid in decision-making. This can include policies, best practice checklists, and proprietary platforms that support your company’s unique structure.

Monitor and course correct.

Continuously evaluate the effectiveness of strategies and adjust as needed.

By following these steps, organizations can leverage the insights of prospect theory to improve decision-making processes and outcomes across business functions and individuals.

Next Steps

For those ready to take action, consider these actionable steps: