Guy Reams (00:01.058)
This is day 133, Prospect Theory and the Weight of our Decisions. One of my favorite ways to challenge my thinking is to dive into studies that have shaped entire industries. Recently, I spent time with one of the most influential pieces of behavioral economics, the Prospect Theory, an analysis of decision under risk by Daniel Kahneman and Amos Tversky. They wrote this in 1979.
It's one of those studies that once you grasp it, you start seeing its effects everywhere, especially in how we make decisions involving risk and reward. At its core, Prospect Theory explains why we don't evaluate potential outcomes rationally. Instead, we distort probabilities in ways that lead to predictable but often irrational behaviors. We fear losses more than we desire equivalent gains.
We believe in unlikely windfalls while also avoiding small risks as if they were catastrophic. Understanding these distortions, especially probability weighting, can help us make better choices in business, finance, and even in our everyday life. Probability weighting. Why our perception of risk is skewed. Probability weighting is one of the most fascinating elements of prospect theory.
It describes how we tend to over weight small probabilities. For example, overestimating the chance of winning the lottery. We under weight large probabilities. For example, underestimating the likelihood of long term success from steady effort. This leads to counter intuitive behaviors. We might take reckless risks when there's a small chance of a big win, like playing the lottery or gambling on a risky investment.
At the same time, we avoid sure bets that carry minor risk, like refusing to invest in a well-diversified fund because of a fear of market downturns. There are other real-world implications of this. Number one, the lottery mindset and the get-rich-quick thinking. Think about how many people spend money on lottery tickets despite the absurdly low odds. The reason?
Guy Reams (02:21.334)
Our brains don't process probabilities logically. A 1 in 300 million chance feels more tangible than it should. The potential windfall is so compelling that we feel like we might win, even though rationally we know it's almost impossible. Two, the fear of remote risks. On the flip side, people often avoid activities with tiny risk that are perceived as catastrophic. Consider how some people refuse to fly due to a fear of crashing,
despite air travel being statistically far safer than driving. The small chance of a disaster looms larger in their minds than it actually should. 3. Risk aversion and gains. When people experience a gain, they tend to become risk adverse. If you've ever played a game of blackjack and decided to walk away after winning a little money rather than pressing your advantage, then you've felt this.
Even in investing, people often sell stocks way too early because they fear losing the gains, rather than riding the wave for greater long-term results. So how to improve decision-making? Recognizing probability weighting is the first step towards making better decisions. Here's how you might apply it. Number one, reframe small probabilities rationally. If you catch yourself making a decision based on tiny probability, ask
Am I overvaluing this outcome just because it's exciting or scary? Whether it's playing the lottery, fearing a plane crash, or avoiding entrepreneurship due to remote failure risks, challenge the weight you're assigning to that probability. Two, use expected value thinking. Instead of thinking, what if I win or what if I lose? Shift to what is the expected value of this decision over time?
This forces a more rational approach to risk and reward. Successful investors and business leaders think in terms of long-term probability rather than just single outcomes. Third, set rules for decision-making. Because our brains are wired to distort probabilities, having structured decision-making rules can help. For example, commit to investing a set amount each month regardless of market fluctuations.
Guy Reams (04:40.832)
Avoid impulse purchases driven by the allure of rare wins. Assess risk logically, using data rather than emotion. Fourth, focus on long-term gains, not short-term certainty. One of the biggest pitfalls of probability weighting is avoiding long-term opportunities because of minor risks. A great example is career advancement. Some people hesitate to take on new responsibilities due to the small chance of failure
even though the long-term benefits of stepping up far outweigh the risk. Learning to lean into probabilities rather than fear them can help us make more courageous and strategic choices. So final thoughts. Prospect theory and probability weighting reveal that our decision-making isn't as rational as we'd like to believe. We chase low probability wins while avoiding small and manageable risk.
But understanding these biases give us the power to step back, reassess, and make choices based on reality rather than distorted perception. The next time you're faced with a decision involving any risk, whether it's an investment, a career move, or even a purchase, pause and ask yourself, am I weighting this probability correctly? This simple moment of reflection could be the difference between chasing a giant illusion and making truly a smart move.