In 2002, Kahneman won the Nobel Prize in Economics for his work in behavioral economics, namely his development of prospect theory with Amos Tversky. Prior to prospect theory, economic theorists believed that the value of money was the sole determinant in explaining why people buy, spend, and gamble in the way that they do. Prospect theory (explained over the course of several chapters of Thinking, Fast and Slow) argues that people’s choices are determined less by the intrinsic value of money, and more by the way in which people feel that their wealth or general circumstances have changed.
Prospect theory reveals that people are “loss averse”—they dislike losing more than they like winning—because they care more about maintaining their current state of wealth than improving it. Kahneman sets up a gamble: if a coin shows tails, the person will lose 100 dollars, but if the coin shows heads, they will win 150 dollars. Even though they stand to gain more than they would lose, most people dislike this gamble because losses loom larger than gains. In another experiment, people are told that they have been given 1,000 dollars. They are then told that they have a 50 percent chance to win 1,000 dollars or they can get 500 dollars for sure. In this scenario, they will usually choose the second option. However, if they are told that they have been given 2,000 dollars and are given a 50 percent chance to lose 1,000 dollars or to lose 500 dollars for sure, they will usually choose the first option. Even though the two scenarios contain the same outcomes, people are risk averse in the first and risk seeking in the second because they intrinsically care more about avoiding a sure loss and are more willing to take a risk. Loss aversion also explains some investors’ behavior: people are more likely to sell stocks that have gained money rather than stocks that have lost money, because they consider the buying price to be a reference point, and they don’t like to add losses to their record. Yet Kahneman points out that the primary consideration when buying stocks is to consider how well a stock might do in the future, not its previous value.
Kahneman then expands his argument to show that the tendency towards loss aversion is true not only with money, but also with objects and goods. A friend of Kahneman’s—whom he calls Professor R—will only buy wines below 35 dollars, but will not sell those same wines for under 100 dollars. Thus, owning the good appears to increase its value because the professor has a higher selling point for the wine than buying it (he dislikes losing the wine more than he likes gaining it). This concept is also true of a person who buys a concert ticket for 200 dollars and is unlikely to sell their ticket, even for a much greater price. Thus, loss aversion appears to be particularly true of goods like tickets (and the wine in the previous example) that are meant to be “for use”—experiences for the person who bought them. Owning the good increases its value.
Loss aversion is then shown not only to be true of money and goods, but also of general psychological experiences. Kahneman asks readers to imagine a company that has already spent 50 million dollars on a project that is behind schedule and is now less likely to bring in money than initially thought. Furthermore, the project now requires an additional investment of 60 million dollars to reach completion. The company is still unlikely to abandon the project because it has already invested money and is averse to taking a sure loss on the project as a whole, when the primary consideration should be the future prospects of that project and whether that money might be better invested somewhere else. In another example, Kahneman reveals that golfers who putt to avoid a bogey (a loss of one stroke over par) putt with more accuracy than golfers who putt to achieve a birdie (a gain of one stroke under par) because they are more averse to taking a loss than to achieving a gain. Kahneman explains that this principle of loss aversion is what keeps people in poor jobs, unhappy marriages, and unpromising research projects for too long.
Kahneman uses prospect theory to demonstrate how our choices about money, goods, and gambles are not always based in monetary value, but in value that is based how a person feels about a prospect, how and when they acquired that prospect, and how much time and effort they have already invested in it. Kahneman admits that the theory is not perfect, but he argues that it allows people to understand their own decisions more concretely and enables them to take a more holistic view of how they buy, sell, and gamble.
Choices, Losses, and Gains ThemeTracker
Choices, Losses, and Gains Quotes in Thinking, Fast and Slow
For most people, the fear of losing $100 is more intense than the hope of gaining $150. We concluded from many such observations that “losses loom larger than gains” and that people are loss averse.
People will more readily forgo a discount than pay a surcharge. The two may be economically equivalent, but they are not emotionally equivalent.