A Modern Guide to Thinking, Fast and Slow

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Part IV - Choices

25. Bernoulli's Errors
26. Prospect Theory
27. The Endowment Effect
28. Bad Events
29. The Fourfold Pattern
30. Rare Events
31. Risk Policies
32. Keeping Score
33. Reversals
34. Frames and Reality

Chapter 25: Bernoulli's Errors

Overview
Bernoulli’s expected utility theory—evaluating options by final wealth with diminishing marginal utility—cannot describe how people actually choose. Economists model “Econs” as rational, selfish agents with stable tastes, but psychologists study “Humans,” whose System 1, limited information, and changing preferences make them sensitive to reference points. Choices depend on perceived gains and losses from a reference point, not on end wealth alone. Humans are also influenced by framing effects, where small changes in wording can reverse preferences.

Kahneman and Tversky's prospect theory is a descriptive alternative that modifies expected utility to explain these patterns.

Replications & Reliability

• Prospect theory: Kahneman & Tversky’s 1979 Econometrica paper is foundational and remains highly cited. The main update is cumulative prospect theory (Tversky & Kahneman, 1992), now the standard formulation in economics and finance. Core components are broadly supported; see Gisbert-Pérez et al., 2022 for a bibliometric and systematic review of the literature.
• Framing effects: The Science article on risky-choice framing (Tversky & Kahneman, 1981) has held up well. A meta-analysis finds a reliable framing effect overall (Kühberger, 1998), and a re-appraisal of it using p-curve methods concludes the effect is real with no evidence of heavy p-hacking (Steiger & Kühberger, 2018).

Recommendations
This chapter is replication-crisis safe and highly valuable. Prospect theory and risky-choice framing are well supported across replications and meta-analyses, and the move from final-wealth utility to reference-dependent evaluation is now standard in economics.

Chapter 26: Prospect Theory

Overview
Kahneman and Tversky's prospect theory is a model of decision making under risk in which people evaluate outcomes as gains or losses relative to a reference point (often the status quo, what they expected, or what they feel entitled to).

The three cognitive features at the heart of prospect theory are reference dependence, diminishing sensitivity, and loss aversion. People tend to be risk averse when it comes to gains and risk seeking when facing sure losses.

Replications & Reliability

• Loss aversion ratio: The claim that the "loss aversion ratio" is usually in the range of 1.5 to 2.5 is reliable. In a 2021 meta-analysis, Brown and colleagues found that the mean loss aversion coefficient is between 1.8 and 2.1.
• "Thinking like a trader": The claim that thinking like a trader reduces loss aversion is based on Sokol-Hessner and colleagues' 2009 study. While the study showed strong effects, the sample size was small (about 30 for both samples) and I am not aware of any independent replications.

Recommendations
This chapter expands on the explanation of prospect theory—Kahneman’s major contribution to economics—and is well worth reading. The core content is useful for understanding real-world choice patterns. Note that the “think like a trader” result is based on a small sample size and would benefit from independent follow-up research.

Chapter 27: The Endowment Effect

Coming soon

Chapter 28: Bad Events

Coming soon

Chapter 29: The Fourfold Pattern

Coming soon

Chapter 30: Rare Events

Coming soon

Chapter 31: Risk Policies

Coming soon

Chapter 32: Keeping Score

Coming soon

Chapter 33: Reversals

Coming soon

Chapter 34: Frames and Reality

Coming soon