Choose one of the following two options;

• Option 1: a sure gain (100% chance) of gaining $ 240,
• Option 2: 25% chance of gaining $ 1000 or a 75% chance of gaining nothing

Which one do you choose?   

Now, choose one of the following two options.

• Option 1: a sure loss (100%) of $750,
• Option 2: 75% chance of losing $1000 or 25% chance of losing nothing.

Which one do you choose?

According to Daniel Kahneman and Amos Tversky, two renowned American Psychologists and the authors of the Prospect theory, 84% chose the first option in the first scenario and 87% chose the second option in the second scenario.    

This is one of the major tenets of the Prospect Theory of Kahneman and Tversky; when we are confronted with a sure gain, we do not take any risks (we averse the risk); however, when we are confronted with a sure or almost sure loss, we take the riskier alternative (we seek the risk to averse the loss).  

Think of this situation now:

You have three bowls; the middle one with water at room temperature, the left one with warm and the right one with cold water; now, immerse your left hand into the warm water and the right hand into cold water; now immerse both hands into the middle bowl. You will experience warm in the right hand and cold in the left hand.

Reference point

So, the above interpretation varies relative to the reference point which is the middle bowl in this case.

Kahneman and Tversky say that the same applies to financial and other situations too. In other situations the reference point is usually the status quo; it can also be the future goal.

So, anything above the reference point is considered as gains and anything below the reference point is considered as losses. We also can change the reference point at any time. 

Now, think of a situation that turning on a weak light in a dark room and turning on the same light in a brightly lighted room. You see the difference. The weak light has a larger impact in the darkroom. Similarly, Kahneman and Tversky say that the perceived difference between $100 and $200 is larger than the difference between $900 and $1000. 

Our differential responses to gains and losses

What is the nature of the relationship in increments of gains and losses relative to the reference point?

To me, this is the most interesting part of this theory; it is S-shaped which is succinctly explained by the following graph.

The top-down line is the neutral reference line which is our perceived psychological value. Anything towards the right side from you is considered gains and anything towards the left side from you is considered as losses.  There is a very interesting point here; this S-shaped curve is not symmetrical to either side of gains and losses.

Observe closely; the loss curve is steeper than the gain curve. How do you interpret that? Kahneman and Tversky say that we respond more strongly to losses than the gains even when the corresponding differences are the same. They name this phenomenon as loss aversion.