# Prospect Theory: What It Is and How It Works, With Examples

![Prospect Theory: The idea that investors place more weight on perceived gains than perceived losses.](https://www.investopedia.com/thmb/D3kc9LTgnopLPL-lYeBHxdbGuzU=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/prospecttheroy-8ae5ed55e7394b4aa1e501b57eb8fe86.png)

*— Hilary Allison / Investopedia*

> **Definition**
>
> Prospect theory holds that people tend to place a greater weight on the potential for loss than the probability of gain when choosing among options.

## What Is Prospect Theory?

Prospect theory suggests that the fear of losses is more compelling than the appetite for gains when humans make decisions. This is also known as [loss aversion](https://www.investopedia.com/terms/l/loss-psychology.asp) theory.

That is, if two equal choices are presented, but one focuses on potential gains and the other emphasizes potential losses, most individuals will choose the first option.

It may sound obvious, but prospect theory is contrary to the common assumption that people weigh risks against rewards in making a decision. They do, but the desire to avoid risk carries more weight than the appetite for a reward.

### Key Takeaways

*   Prospect theory examines how individuals make choices.
*   The theory states that investors value gains and losses differently, prioritizing avoidance of risk.
*   In the context of investing, it suggests that an investor presented with two equal choices will choose the one presented in terms of likely gains over potential losses.
*   Prospect theory is part of behavioral economics.

## How Prospect Theory Works

Prospect theory belongs to the [behavioral economics](https://www.investopedia.com/terms/b/behavioraleconomics.asp) branch of psychology. It focuses on how individuals choose between alternatives when risk is involved and various outcomes are possible.

The theory was formulated in 1979 and further developed in 1992 by economists Amos Tversky and Daniel Kahneman. They deemed it more psychologically sound than an alternative, the expected utility theory.

Expected utility theory suggests that, given two alternatives, rational people will go for the option that offers the most satisfactory outcome.

### Loss Is Hard

Prospect theory assumes that people consider the chances of a gain or a loss in any choice are roughly 50/50.

However, the fear of loss has greater weight. Tversky and Kahneman proposed that a loss has a greater emotional impact than an equivalent amount of gain. So, given choices presented two ways—with both offering the same result—most individuals will pick the option offering a perceived gain rather than the one that communicates a possible loss.

### The Logic of "Equal" Choices

For example, assume that an individual is offered $25. Either $25 will be handed over immediately or the person will be given $50 but will have to give back $25.

In either case, the person will receive $25. The "utility" of the two offers is identical.

However, individuals will take the $25 paid outright. The gain is seen as more favorable than a greater gain followed by a loss.

## The 2 Phases of Decision-Making

It is virtually impossible to consider all available information and every possible outcome. So, prospect theory suggests, humans use a two-step process to narrow down the most important information.

These steps are the editing phase and the evaluation phase.

### The Editing Phase

In the editing phase, the person facing a decision decides which information will be used.

Mental shortcuts are used to assess which information is important and what options are available. The most desirable outcomes are identified and priorities are ranked.

The editing phase can introduce biases that emerge later in the decision process.

If the individual does not consider certain unlikely outcomes or makes an incorrect assessment of that outcome's probability, they may end up making a poor decision.

### The Evaluation Phase

This is the stage where the final decision is made, based on the assessments made in the editing phase.

The decision-maker weighs the probability of each outcome and takes action based on the perceived likelihood and desirability of each outcome.

It is important to note that these decisions are not necessarily based on rational calculations. Prospect theory posits that people tend to be risk-averse when the stakes are high, and risk-accepting when the stakes are low.

In other words, they make choices that minimize possible losses rather than maximize possible gains.

## Characteristics of Prospect Theory

Prospect theory suggests that humans tend to prefer certainties over probabilities.

Prospect theory also asserts that people underestimate or even ignore outcomes with a low probability.

Consequently, they also tend to overestimate the probability of likely events, resulting in a bias that neglects improbable outcomes. This is particularly relevant to investors, who must consider the possibility of [black swan events](https://www.investopedia.com/articles/trading/11/black-swan-events-investing.asp).

## How to Overcome Biases

Understanding prospect theory can help individuals overcome their biases and make more rational choices.

For example, an investor who is aware of a bias toward high-probability events can compensate by giving extra consideration to low-probability ones.

It also helps to reframe possible outcomes in a way that reduces the impact of cognitive biases. Instead of thinking in terms of gain or loss, think in terms of the value of expected outcomes, without using the present as a reference point.

This can reduce one’s loss aversion bias.

## Outcomes

According to Tversky and Kahneman, the certainty effect is exhibited when people prefer certain outcomes and avoid outcomes that are only probable.

The certainty effect leads to individuals avoiding risk when there is a prospect of a sure gain. It also contributes to individuals seeking risk when one of their options is a sure loss.

The isolation effect occurs when people are presented with two options with the same outcome, but different routes to the outcome.

In this case, people are likely to cancel out similar information to lighten the cognitive load, and their conclusions will vary depending on how the options are framed.

## Example of Prospect Theory

Consider an investor who is given two pitches for the same [mutual fund](https://www.investopedia.com/terms/m/mutualfund.asp).

The first advisor presents the fund to Sam, highlighting its average return of 10% for the last three years.

A second advisor tells Sam that the fund has had above-average returns over the last decade, although the returns for the last three years have been lower than those in the previous years.

According to prospect theory, Sam is likely to invest in the fund based on the first advisor's description of it.

That is, the investor is more likely to buy the fund from the advisor who expresses the fund’s [rate of return](https://www.investopedia.com/terms/r/rateofreturn.asp) only in terms of its gains, while the second advisor zeroed in on its declining rate of return.

## What Does Prospect Theory Mean?

Prospect theory says that investors value gains and losses differently. The desire to avoid losses, or potential losses, weighs more heavily than the potential gain.

## How Is Prospect Theory Relevant to Me?

Prospect theory can identify the biases that can affect investing decisions. The biases are rooted in an aversion to losses. Nobody wants losses but risk aversion can weigh too heavily, having an outsized impact on gains.

## What Are the Main Components of Prospect Theory?

Prospect theory describes how individuals make decisions between alternatives where risk is involved and the probability of different outcomes is unknown. There is a certainty effect exhibited in prospect theory, in which people seek certain outcomes, [underweighting only probable outcomes](https://www.investopedia.com/articles/financial-theory/controversial-financial-theories.asp).

## The Bottom Line

Prospect theory says that individuals will accept an investment when the gains are presented, vs. the losses. That is, investors prefer potential gains over potential gains with greater risk.

> **Article Sources**
>
> 1.  Tversky, Amos, and Daniel Kahneman, via JSTOR. “[Prospect Theory: An Analysis of Decision Under Risk](https://www.jstor.org/stable/1914185).” _Econometrica_, vol. 47, no. 2, March 1979, pp. 263–292.
>     
> 2.  Tversky, Amos, and Daniel Kahneman, via California State University Fullerton, Psychology Department. “[Advances in Prospect Theory: Cumulative Representation of Uncertainty](https://psych.fullerton.edu/mbirnbaum/psych466/articles/Tversky_Kahneman_JRU_92.pdf).” _Journal of Risk and Uncertainty_, vol. 5, 1992, pp. 297–323.
>     
> 3.  Stanford Encyclopedia of Philosophy. "[Normative Theories of Rational Choice: Expected Utility](https://plato.stanford.edu/entries/rationality-normative-utility/)."
>     
> 4.  ScienceDirect. “[Prospect Theory](https://www.sciencedirect.com/topics/neuroscience/prospect-theory).”
>     
> 5.  Simply Psychology. “[Prospect Theory in Psychology: Loss Aversion Bias](https://www.simplypsychology.org/prospect-theory.html).”
>     
> 6.  Simply Psychology. “[Prospect Theory in Psychology: Loss Aversion Bias](https://www.simplypsychology.org/prospect-theory.html).”
>     
> 7.  Amy Perfors and Nicholas T. Van Dam. “[Human Decision Making in Black Swan Situations](https://psychologicalsciences.unimelb.edu.au/__data/assets/pdf_file/0009/2800746/PerforsVanDam2018.pdf),” Page 1.
>     
> 8.  Tversky, Amos, and Daniel Kahneman, via JSTOR. “[Prospect Theory: An Analysis of Decision Under Risk](https://www.jstor.org/stable/1914185).” _Econometrica_, vol. 47, no. 2, March 1979, pp. 265, 271, 274.