People evaluate outcomes relative to a reference point rather than in absolute terms, are loss-averse, show diminishing sensitivity, and overweight small probabilities.
Kahneman and Tversky's Nobel Prize-winning theory describes how people actually make decisions under risk, challenging expected utility theory. The key components: reference dependence (outcomes evaluated relative to a reference point), loss aversion (losses hurt more than gains feel good), diminishing sensitivity (marginal value decreases with size), and probability weighting (small probabilities overweighted, moderate ones underweighted). This explains why people simultaneously buy insurance and lottery tickets, why framing matters, and why the same choice presented as a gain or loss produces different decisions.
A salary offer of $120,000 feels low if your reference point is $140,000 (your expectation) but high if your reference point is $100,000 (your current salary). The same objective outcome is evaluated differently based on the reference point.
Prospect theory tells you how you should decide—it's descriptive (how people do decide) not normative (how they should decide).
Using prospect theory, explain why the same person might buy both lottery tickets and insurance.
Logically equivalent choices produce different decisions when framed differently (as gains vs. losses, or with different reference points).
PrincipleContinuing an endeavor because of previously invested resources (time, money, effort) that cannot be recovered, even when continuing is irrational.
PrincipleFast, automatic, unconscious cognitive processing that operates through pattern recognition and associative memory without deliberate effort.
Mental ModelSlow, effortful, conscious cognitive processing required for complex calculations, unfamiliar tasks, and deliberate reasoning.
Mental ModelThe tendency to rely too heavily on the first piece of information encountered (the anchor) when making decisions, even when it's arbitrary or irrelevant.
PrincipleJudging the frequency or probability of events by how easily examples come to mind, leading to overestimation of vivid, recent, or emotional events.
PrincipleJudging probability by similarity to stereotypes or prototypes, while ignoring base rates and sample size.
PrincipleWhen faced with a difficult question, System 1 automatically substitutes an easier question without conscious awareness of the switch.
FrameworkLasting behavior change comes from shifting your identity (who you are) rather than focusing on outcomes (what you achieve).
from “Atomic Habits”
A specific plan that states when, where, and how you will execute a behavior: 'I will [behavior] at [time] in [location].'
from “Atomic Habits”
Pair an action you need to do with an action you want to do to make habits more attractive.
from “Atomic Habits”
Behavior change operates at three levels: outcomes (what you get), processes (what you do), and identity (what you believe).
from “Atomic Habits”
Identity changes through accumulated evidence: each habit execution is a vote for the type of person you want to become.
from “Atomic Habits”
People evaluate outcomes relative to a reference point rather than in absolute terms, are loss-averse, show diminishing sensitivity, and overweight small probabilities.
A salary offer of $120,000 feels low if your reference point is $140,000 (your expectation) but high if your reference point is $100,000 (your current salary). The same objective outcome is evaluated differently based on the reference point.
Prospect theory tells you how you should decide—it's descriptive (how people do decide) not normative (how they should decide).
Prospect Theory is explored in depth in "Thinking, Fast and Slow" by Daniel Kahneman. Distilo provides a deep AI-powered analysis with key insights, audio narration, and practical frameworks.