Loss Aversion in Prospect Theory:

Loss Aversion in Prospect Theory:

Loss aversion is a key concept in Prospect Theory, developed by Daniel Kahneman and Amos Tversky, which describes how people make decisions under conditions of risk and uncertainty.

Definition of Loss Aversion:

Loss aversion refers to the tendency for people to strongly prefer avoiding losses over acquiring equivalent gains. In other words, losing $100 feels more painful than the pleasure of gaining $100.

In the Context of Prospect Theory:

• Value function is steeper for losses than for gains.
• This means the psychological impact of a loss is roughly twice as powerful as a gain of the same size.
• The function is also:
• Concave for gains → risk-averse when gaining.
• Convex for losses → risk-seeking when losing.

Example:

• Gain scenario: You’re given the choice between:
• A sure gain of $500
• A 50% chance to gain $1,000
   → Most people choose the sure gain (risk-averse in gains).
• Loss scenario: You’re given the choice between:
• A sure loss of $500
• A 50% chance to lose $1,000
   → Most people take the gamble (risk-seeking in losses).

Why It Matters:

• It helps explain why people hold on to losing stocks (to avoid realizing a loss).
• It influences consumer behavior, insurance decisions, negotiations, and more.
• It’s a core departure from classical economics, which assumes rational, utility-maximizing behavior.

Shervan K Shahhian