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Prospect theory

Prospect theory - Sketchplanations

Dan Kahneman and Amos Tversky’ s behavioural economics theory modeling how we make decisions. It illustrates, among other things, some of the non-rational decisions we make as we are guided by emotion and heuristics in decisions. The sketch points out a few of the key points:

Loss aversion - the different shape of the curves as we make gains or losses (either side of the centre) represents how a loss of £100 annoys us much more than a gain of £100 gives us pleasure.
Diminishing sensitivity - the levelling off of the curves represents that we’ll enjoy winning £100, if we only have £100, much more than we’d enjoy winning £100 if we had £900.
Adaptation level - We don’t evaluate from some absolute level - we evaluate whether something is good or bad from a neutral reference point that we adapt to. So, by the end of a movie the movie theatre doesn’t feel dark, yet walking out feels blinding. Your reaction to the £100 example above was probably affected by whether you think £100 is a lot of money or a little, which is all to do with your adaptation level.

Published 14 May 2015

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Keep exploring

The Availability Heuristic illustration: Plane crashes, cold snaps, and winning lottery tickets are shown as examples of uncommon but widely reported events that might affect the significance we associate with them.

The availability heuristic (and bias)

Leading from any chair, the fifth practice from The Art of Possibility by Benjamin and Rosamund Zander. From Eugene Lehner's story: What would I say should I suddenly be called upon to lead?

Leading from Any Chair

Deseed a Pomegranate illustration: this 5-stage process shows how to separate the seeds from within a pomegranate using the back of a spoon and a bowl of water.

Deseed a pomegranate

The Barnum effect (also the Forer effect) illustrated by 3 people, each getting the same seemingly personalised personality test result and figuring it described them perfectly.

The Barnum effect

Blooms Taxonomy explanation: A series of 6 building blocks are stacked on top of each other, decreasing in size as they go up, creating a pyramid-style construction. Each block represents one of 6 thinking skills. These skills become more sophisticated as the pyramid climbs and reminds us that the foundation of learning is knowledge.

Bloom's Taxonomy

Pyrrhic victory: King Pyrrhus laments a victory that wasn't worth winning as he surveys the remains of his troops after a victory on the battlefield

Pyrrhic victory

The availability heuristic is a deceptively simple, almost too simple to notice, heuristic where we consider the likelihood of events by the ease with which relevant instances come to mind. In simple terms, things that we can easily recall or where we can think of examples, we generally consider as more important or more common than other things. A heuristic is a mental shortcut to solve a common problem. If we were asked to consider the divorce rate in the community, we might evaluate that by considering how many of our acquaintances are divorced. If none of your friends are divorced, you’re naturally less likely to think the divorce rate locally will be high. In many situations, it makes good sense to give credence to what you remember easily. However, in situations involving probabilities, in particular, the heuristic will lead us predictably astray such that more often I think of it as an availability bias — a predictable pattern of thought and behaviour leading to incorrect conclusions. So, the vividness of shark attacks causes us to overrate how likely they are to actually occur. Or we’re more likely to worry about lions than hippos, even though hippos kill more people each year than lions. Or the risk of being struck by lightning vs stuck by a car crossing a road. Or, the prevalence of violent crime on the news compared to the likelihood of you being a victim. Or the fact that it’s cold outside and yet the planet is gradually warming. Here’s a 1973 Kahneman and Tversky paper: Availability: A Heuristic for Judging Frequency and Probability…The availability heuristic is a deceptively simple, almost too simple to notice, heuristic where we consider the likelihood of events by the ease with which relevant instances come to mind. In simple terms, things that we can easily recall or where we can think of examples, we generally consider as more important or more common than other things. A heuristic is a mental shortcut to solve a common problem. If we were asked to consider the divorce rate in the community, we might evaluate that by considering how many of our acquaintances are divorced. If none of your friends are divorced, you’re naturally less likely to think the divorce rate locally will be high. In many situations, it makes good sense to give credence to what you remember easily. However, in situations involving probabilities, in particular, the heuristic will lead us predictably astray such that more often I think of it as an availability bias — a predictable pattern of thought and behaviour leading to incorrect conclusions. So, the vividness of shark attacks causes us to overrate how likely they are to actually occur. Or we’re more likely to worry about lions than hippos, even though hippos kill more people each year than lions. Or the risk of being struck by lightning vs stuck by a car crossing a road. Or, the prevalence of violent crime on the news compared to the likelihood of you being a victim. Or the fact that it’s cold outside and yet the planet is gradually warming. Here’s a 1973 Kahneman and Tversky paper: Availability: A Heuristic for Judging Frequency and Probability

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