This article is an excerpt from the Shortform summary of "Thinking, Fast and Slow" by Daniel Kahneman. Shortform has the world's best summaries of books you should be reading.
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Why do we fear losses more than we value gains, or obsess over unlikely disasters while downplaying probable success? Psychologist Daniel Kahneman’s prospect theory reveals that emotions—not pure logic—drive most of our choices.
Prospect theory explains how we evaluate options based on reference points rather than absolutes, why proportional changes matter more than fixed amounts, and why loss aversion shapes our behavior more powerfully than any potential reward. Learn more about how understanding prospect theory can help you recognize emotional biases in your own decision-making and make more intentional choices.
- Originally Published: November 7, 2019
- Last Updated: December 9, 2025
Prospect Theory Accounts for Human Emotions
If people don’t make decisions based on pure rationality and expected value, how do they make decisions? To answer that question, Kahneman developed prospect theory, which factors in various ways that emotions influence judgment.
The author summarizes prospect theory in three points:
1. You evaluate situations by comparing them to a neutral reference point. Your reference point is usually your status quo—the situation you normally experience—meaning you make decisions that you think will improve your status quo. However, your reference point can also be an outcome you expect or feel entitled to, like an annual raise. That’s why you can feel crushed when you don’t get something you expected even though your situation hasn’t actually changed.
(Shortform note: Arguably, your status quo is also an expectation: You expect your current situation to continue. So, we can sum up this aspect of prospect theory using the “equation” happiness equals reality minus expectations. This formula explains why you’re unhappy when reality doesn’t live up to your expectations: Your happiness is negative. Thus, according to this “formula,” the simplest way to become happier is to lower your expectations. In theory, if expectations = 0 (that is, if you have no expectations at all) you’ll be happy with whatever reality you have. That’s one way to approach what Tara Brach calls Radical Acceptance—not expecting or anticipating anything, but simply accepting each moment as it comes.)
2. Your evaluations are proportional, rather than fixed. Kahneman explains that you judge value as a percentage of what you already have. For example, rationally speaking, gaining $100 should always have the exact same value. However, going from $100 to $200 (a 100% increase) feels much more significant than going from $1,000 to $1,100, which is only a 10% increase. To extend the example, if you were already a millionaire, $100 wouldn’t even seem worth your notice—it would be a fraction of a percent of what you already have, and barely feel different from finding a quarter on the ground.
(Shortform note: These proportional evaluations make more sense when you consider that you often don’t need, nor even want, more of something that you already have a great deal of. This idea is closely related to what economists call the Law of Diminishing Marginal Utility: The more of something you have, the less benefit you experience from getting one more of that thing. This is why $1 is practically worthless to someone who already has a lot of money, but for someone in poverty, one more dollar might allow them to afford a meal or some other necessity. For another example, suppose you’re very thirsty; you’d greatly value a glass of water, but a second glass would hold significantly less benefit for you, and a third would have less value still.)
3. Losses of a certain amount trigger stronger emotions than a gain of the same amount. To give a fairly mundane example, the happiness you feel when a bartender hands you a drink is much less than the disappointment you’d feel if you spilled it. Kahneman says this phenomenon, called loss aversion, is a result of evolution: Organisms that treat threats more urgently than opportunities tend to survive and reproduce better.
(Shortform note: While Kahneman presents loss aversion as an irrational bias in our thinking, statistician Nasim Nicholas Taleb argues that it’s actually extremely rational. In Skin in the Game, Taleb says loss aversion is a symptom of our instinct to prevent ruin—a loss so great that it’s impossible to recover from. Taleb notes that opportunities for ruin-inducing losses are all around us, and that small losses can add up over time and ruin us. Therefore, it’s rational that we have strong emotions regarding losses: Logically, we should do everything we can to avoid even the smallest possibility of ruin.)
Kahneman also discusses some practical implications of prospect theory. Two key implications are the possibility effect and the certainty effect.
Implication #1: The Possibility Effect
Kahneman says that people will overvalue the mere possibility of something happening, even if it’s still highly unlikely.
As an example, consider which of these options seems more meaningful:
- Going from a 0% chance of winning $1 million to a 5% chance
- Going from a 5% chance of winning $1 million to a 10% chance
Most likely you had a stronger response to the first option, even though the objective increase in value is the same for both.
The possibility effect explains why people fantasize about small chances of big gains—such as when they go to casinos or play the lottery. It also explains why people obsess over worst-case scenarios, even when there’s only a tiny chance of those scenarios coming to pass.
| The Possibility Effect Makes Sense for Extreme Events Similar to our previous discussion of ruin, the Possibility Effect may be more rational than it first appears, especially when dealing with extreme situations. When assessing the risk level of a negative event, it’s crucial to factor in both the likelihood of that event happening and its impact if it does happen. Therefore, going from no chance of an event happening (zero risk) to even a small chance (some risk) is, proportionally, an infinite increase in risk. For example, this is why many people argue against building nuclear power plants: While the odds of another event like Chernobyl are very low, the impact would be so catastrophic that people find even the possibility unacceptable. We can also invert this idea to account for positive events, such as the above example of winning $1 million—going from a 0% to a 5% chance is an infinite increase in your odds of getting rich. Conversely, going from a 5% chance to a 10% chance is much less impactful; the possibility already existed, now it’s just slightly more likely to happen. |
Implication #2: The Certainty Effect
Just like people overvalue the idea of a previously impossible outcome becoming merely unlikely, Kahneman says we also place too much value on the idea of a likely outcome becoming certain.
To illustrate this, consider the following situations:
- You’re in the hospital, and your prognosis goes from a 90% chance of recovery to a 95% chance of recovery.
- You’re in the hospital, and your prognosis goes from a 95% chance of recovery to a 100% chance of recovery.
Most likely, you felt better about the second than the first. This demonstrates how people overvalue absolute certainty, and undervalue outcomes that are almost guaranteed but not quite certain. A 95% chance of recovery is actually a great prognosis, but it doesn’t feel that way because the remaining 5% continues to bother you.
(Shortform note: Neuroscience can provide an explanation for why we value certainty so highly. When we face uncertain situations, specific regions in the brain become hyperfocused on potential threats. When this happens, uncertainty consumes parts of our working memory that we’d otherwise use for focus, creativity, and decision-making. Therefore, by eliminating uncertainty, we ease our anxiety and become better able to make thoughtful, well-reasoned choices. In other words, certainty doesn’t just make us feel more confident in our decisions, in many cases it actually allows us to make better decisions than we could while distracted by possible dangers and “what-if” thoughts.)
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- Why we get easily fooled when we're stressed and preoccupied
- Why we tend to overestimate the likelihood of good things happening (like the lottery)
- How to protect yourself from making bad decisions and from scam artists
