Prospect theory
How people really decide under risk — gains and losses measured from a reference point, not final wealth.
What it means
Prospect theory is a descriptive theory of choice under risk that supplanted expected utility as the leading account of how people actually behave when outcomes are uncertain. Its core claims are that people evaluate outcomes as gains and losses relative to a reference point rather than as absolute states of wealth, that losses loom larger than equivalent gains (loss aversion), that sensitivity to both gains and losses diminishes as they grow larger (an S-shaped value function), and that probabilities are transformed by a nonlinear weighting function that overweights rare events and the move from possible to certain. A separate editing phase, in which prospects are simplified and framed before they are evaluated, makes choices sensitive to how options are described. The theory is descriptive rather than normative — it predicts systematic violations of rationality rather than prescribing optimal choice — and the 1992 cumulative version repaired technical problems with how probabilities combine. It matters because it unifies the endowment effect, the disposition effect, framing, and insurance-and-lottery demand under a single mechanism, and it earned Kahneman the Nobel Prize in economics.
Examples
Most people refuse a 50/50 bet to win $110 or lose $100, because the prospective $100 loss looms larger than the larger $110 gain.
Investors sit on falling shares and sell the rising ones: until you sell, the loss is not yet real, and each further pound of it hurts less than the first.
A £2,000 rise delights someone who expected nothing and stings someone promised £5,000 — the same salary, judged from two different reference points.
First described in Kahneman & Tversky (1979); cumulative version 1992.