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Prospect theory explains decision making under uncertainty from "summary" of Thinking Fast and Slow by Book Summary
Prospect theory provides a framework for understanding how people make decisions when faced with uncertainty. It suggests that individuals do not always behave rationally when assessing potential gains and losses. Instead of evaluating outcomes in absolute terms, they tend to focus on changes from a reference point, such as their current state or expectations. When faced with a decision involving risk, individuals weigh potential losses more heavily than equivalent gains. This asymmetry in decision-making leads to risk aversion when considering positive outcomes and risk-seeking behavior when facing potential losses. People are generally more willing to take risks to avoid losses than to achieve gains of the same magnitude. Furthermore, Prospect theory proposes that individuals tend to overweight small probabilities and underweight large probabilities when making decisions under uncertainty. This tendency can lead to irrational choices, as individuals may prioritize unlikely but extreme outcomes over more probable but moderate ones. Another key aspect of Prospect theory is the concept of mental accounting, which refers to how individuals categorize and evaluate financial outcomes based on their frame of reference. People often compartmentalize their financial decisions, treating gains and losses in one category differently from those in another. This compartmentalization can result in suboptimal decision-making, as individuals may fail to consider the overall impact of their choices across different accounts.- Prospect theory highlights the complex and often irrational nature of decision-making under uncertainty. By understanding how individuals perceive and evaluate risks, gains, and losses, we can gain insights into the factors that influence their choices and behaviors in various situations.
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