The findings of behavioral economists regarding risk aversion can best be summarized by the phrase, "losses loom larger than gains." From a behavioral perspective, the pain of losing is always greater than the pleasure of winning.

Behavioral economics examines economic behavior from a psychological viewpoint rather than a microeconomic one. Economic agents aren't assumed to be utility maximizers or even rational; instead, their decisions are parsed for clues about true preferences and biases. The field has grown in prominence; people make a lot of economic decisions that are informed by psychology rather than numbers.

Prospect theory is one of these areas. It challenged neoclassical economic notions of behavior by documenting the tendency for people to behave differently under risk depending on whether they're facing a potential loss or a potential gain.

Decision making under risk is a two-step process, according to prospect theory. First, the decision is edited, or simplified, in terms of its potential gains and losses. Paying $10 for a chance to win a new car involves a loss of $10 and a slight chance of gaining a new car.

The second stage involves evaluation, which is a rough assessment of the probability of different outcomes and their value to the person. It's important to note that "probability" doesn't necessarily mean an actual numerical probability. Rather, it refers to the person's rough estimation of something occurring. The decision-maker might decide that there is roughly a 5% chance of winning the car even if the true probability is only 0.005%. Prospect theory also finds that people have a tendency to overweight low probabilities.

There are three critical characteristics of the decision-making process described by prospect theory. First, the theory acknowledges that people don't make decisions in a vacuum. Spending $10 on the chance to win might feel very different depending on whether that $10 was found on the floor a few minutes previously or whether the person just lost $100 on similar gambles. This comparison set is called the reference point.

Secondly, potential losses or gains closer to the reference point are given a higher value than those far away from the reference point. For the person who already spent $100 on similar gambles, another $10 might seem like a fairly big expense. For the person who already spent $1,000 on those gambles, another $10 might seem like nothing.

Third, and most importantly from a risk perspective, the theory holds that losses are more painful than gains are pleasurable. In other words, there is more pain involved in losing $10 than there is pleasure in winning $10.

This relationship explains why framing features so prominently in behavioral research: no contest organizer in his right mind would describe the above gamble as "an almost 100% certain way to lose $10!" Rather, it's framed in terms of a very large potential gain relative to the cost of entry. The gain has to be higher than the amount on the line, otherwise most people will determine that the risk isn't worth it.

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