Prospect Theory and the Psychology of Uncertainty

How we make decisions under risk; and what this means for everyday life.

Jun 15, 2025

Welcome to The Wealthy Sage Newsletter, where clarity meets action and connection leads to sustainable success. This post is part of my Develop Self and Other series exploring clarity, growth, and leadership so we can all act with greater wisdom in the world.

Here’s the scenario:

You’re offered a refund of $100. Relief.
Then you’re told you missed out on a $100 bonus. Frustration.

These are the same amounts but different feelings.

Why? Because we don’t react to gains and losses equally, and that imbalance silently shapes our choices.

Today’s theme explores the above scenario through the lens of Prospect Theory, a powerful explanation of how we actually make decisions when the outcomes are uncertain, and what that means for how we live.

What Is Prospect Theory?

Prospect Theory is a behavioural model of decision-making under conditions of uncertainty, developed by psychologists Daniel Kahneman and Amos Tversky in 1979.

It challenged a central assumption in economics:

That people are rational agents who evaluate choices logically to maximise expected value.

Kahneman and Tversky showed that we’re far less rational than we like to think, especially when risk or emotion is involved. We rely on shortcuts, respond to framing, and most of all, we’re heavily influenced by how things are presented.

What Does Prospect Theory Explain?

It reveals the hidden patterns behind our decisions, especially around potential gains and losses.

🔑 Core Insights

We think in relative terms — not absolutes.
We evaluate outcomes based on where we are now or what we expected, and not final results.
Losses hurt more than gains feel good.
The pain of losing $100 is roughly twice as intense as the pleasure of gaining $100.
We’re risk-averse with gains, risk-seeking with losses.
We prefer a guaranteed win, but we’ll gamble to avoid a loss, even if it’s illogical.
We are influenced by framing.
The same choice, described in different ways, can lead to completely different decisions.

The Power of Framing: Same Facts, Different Choices

One of Kahneman and Tversky’s most famous experiments showed how simply changing the wording of a problem affects what people choose.

🧪 The “Asian Disease” Problem

Imagine a disease outbreak expected to kill 600 people.

Group A was told:
- Program 1: 200 people will be saved.
- Program 2: 1/3 chance that all 600 will be saved, 2/3 chance that no one will be saved.

Most chose Program 1 — the safe, certain option.

Group B saw the same scenario, but framed differently:
- Program 3: 400 people will die.
- Program 4: 1/3 chance that no one will die, 2/3 chance that all 600 will die.

Most chose Program 4 — the riskier loss.

Although all four programs are mathematically identical, the framing (lives saved vs. lives lost) flipped people’s preferences.

What Can We Learn from This?

Here are four ways how to use this knowledge in your daily life:

🧭 1. Beware of Loss Aversion

We’re biologically wired to avoid losses more intensely than we pursue gains. This once served us well in survival but in modern life, it can trap us.

We avoid risks that might benefit us.
We hold on to things longer than we should (bad investments, outdated goals).
We resist change even when we’re unhappy because change feels like a potential loss.

We’re not the only ones who fall into this trap…

🐾 Remember the old fable about the dog with a bone?
The dog is on the river bank, bone in mouth, when he sees his reflection in the water. Thinking it’s another dog with a juicier bone, he takes a closer look, snaps at the reflection — and promptly drops his bone.
It’s usually told as a lesson about greed. But it’s also a cautionary tale about how we react to perceived opportunity without stopping to weigh what we already have — a classic framing misfire that ends in regret.
🔍 Ask yourself: Am I seeing clearly — or reacting to a misconstrued perception of value?

🧭 2. Watch for Hidden Reference Points

We judge outcomes not on their absolute value, but on how they compare to what we expected.

A 5% investment return might feel disappointing if you expected 8% — but thrilling if you expected 2%.

🔍 Ask: Is my disappointment real — or just a mismatch with my expectations?

🧭 3. Notice When You’re Being Framed

We’re deeply influenced by how choices are presented. The same information, framed differently, triggers completely different reactions.

🔍 Ask: Would my decision change if this were framed in terms of gain rather than loss (or vice versa)?

🧭 4. Recognise How You Handle Risk

We behave differently when we feel ahead than when we feel behind. That shift in mindset affects how much risk we tolerate — often without us noticing.

We might take a reckless job leap to escape a bad situation, when a calmer path — like exploring options from a stable role — could serve us better.

🔍 Ask: Am I reacting to facts — or to the feeling of being behind?

Final Thought… and a Challenge

Prospect Theory doesn’t just explain why we make irrational decisions, it also helps us notice when we’re doing it.

This week, choose one decision you’ve been putting off. Simply pause, and ask:

What am I afraid to lose?
What am I comparing this to?
Is my hesitation based on facts, or on how those facts feel?

Decide with awareness, not reflex.
That’s how we move from automatic reaction to intentional action.

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