Have you ever wondered why people don’t always make rational decisions when faced with choices? Well, it turns out that a theory called “prospect theory,” developed by the author Daniel Kahneman, challenges the idea that we always act in the most rational way. Let’s consider two scenarios: In the first one, you receive $1,000 and have to choose between getting a guaranteed $500 or taking a 50 percent chance to win another $1,000. In the second scenario, you start with $2,000 and have to decide between a certain loss of $500 or taking a 50 percent chance of losing $1,000.

If we were purely rational beings, we would make the same choice in both cases. However, that’s not what usually happens. In the first scenario, most people prefer the sure bet, while in the second, they tend to take a risk. Prospect theory helps us understand why this happens. It reveals two key reasons why we don’t always act rationally, and both of them have to do with our fear of losses.

Firstly, we often value things based on reference points. Starting with different amounts of money in the two scenarios affects how we make decisions. The reference point in the first scenario is $1,000, and in the second, it’s $2,000. So, ending up with $1,500 feels like a win in the first scenario but a disappointing loss in the second. Even though this may seem irrational, our perception of value is influenced by where we start.

Secondly, we are affected by the principle of diminishing sensitivity, meaning we perceive the value of gains and losses differently than their actual worth. For example, going from $1,000 to $900 doesn’t feel as bad as going from $200 to $100, even though the monetary value of both losses is the same. Similarly, in our examples, the perceived loss from going from $1,500 to $1,000 feels greater than going from $2,000 to $1,500. In summary, prospect theory helps us understand that our decisions are often influenced by our emotions and how we perceive gains and losses, rather than just pure logic and rationality.