Prospect Theory | Why Do We Fear Losses More Than We Value Gains?

Prospect theory describes how individuals assess potential outcomes in terms of gains and losses relative to a specific reference point, rather than in absolute terms. This evaluation is not symmetrical. The core of this concept is the value function, which is an S-shaped curve that is steeper for losses than for gains. This demonstrates a principle called 'loss aversion,' a cognitive bias where the psychological pain of losing a certain amount is roughly twice as powerful as the pleasure of gaining the same amount. For instance, the distress from losing $50 is significantly more intense than the happiness from finding $50. Furthermore, the value function illustrates 'diminishing sensitivity.' This means that the difference between a $10 gain and a $20 gain feels more significant than the difference between a $1010 gain and a $1020 gain. The same principle applies to losses. Our decisions are therefore not based on the final outcome, but on the subjective value we assign to the change from our current state, making our choices context-dependent and seemingly irrational.

Humans do not process probabilities objectively. Prospect theory introduces the 'probability weighting function' to explain this distortion. We tend to 'overweight' small probabilities and 'underweight' moderate to high probabilities. This explains why state lotteries, which have extremely low probabilities of winning, are so popular; we perceive the minuscule chance of winning as being more significant than it actually is. Conversely, we underweight almost certain outcomes. For example, a 95% chance of success is often treated as less certain than it is, leading to risk-averse behavior. This subjective weighting of probabilities is a fundamental departure from expected utility theory, which assumes a linear and rational response to probability. Our choices under risk are therefore influenced not just by the potential outcomes, but by our biased perception of how likely they are to occur.

The 'framing effect' is a cognitive bias where the way information is presented, or 'framed,' significantly affects decision-making. According to prospect theory, framing a choice in terms of potential gains or potential losses dictates our risk preference. For example, a medical treatment described as having a "90% survival rate" is perceived much more favorably than one described with a "10% mortality rate," even though they are statistically identical. When options are framed as gains, people tend to be risk-averse and prefer a sure thing. When the same options are framed as losses, people become risk-seeking, willing to gamble to avoid a certain loss. This applies to consumer choices, financial investments, and public policy decisions.

The 'endowment effect' is the tendency for individuals to place a higher value on an object they own than they would be willing to pay for the same object if they did not own it. This phenomenon is a direct consequence of loss aversion as described by prospect theory. Once an item becomes part of our endowment, or possessions, giving it up is perceived as a loss. Because losses loom larger than equivalent gains, the price a seller demands to part with an object (to compensate for the pain of loss) is often significantly higher than the price a buyer is willing to pay to acquire it (the anticipated pleasure of gain). This is consistently observed in experimental and real-world markets.

Neuroscience provides a biological basis for the principles of prospect theory, especially loss aversion. Functional magnetic resonance imaging (fMRI) studies show that distinct neural circuits are involved in processing potential gains and losses. The brain's reward pathways, including the ventral striatum, show increased activity in response to potential gains. In contrast, potential losses trigger heightened activity in the amygdala, a region critical for processing fear and threat. Critically, studies reveal that the amygdala's response to a potential monetary loss is significantly stronger than the reward system's response to an equivalent gain. This neural asymmetry provides a direct correlate for the psychological principle of loss aversion. The brain is effectively hardwired to be more sensitive to negative outcomes than to positive ones, which drives the risk-averse behavior observed when we face potential losses from our current reference point.

Prospect Theory