Gary Belsky

When we incur a loss or expense, we prefer to hide it from ourselves within a bigger loss or expense.

Its title is “Prospect Theory: An Analysis of Decision Under Risk.” And if Richard Thaler’s concept of mental accounting is one of two pillars upon which the whole of behavioral economics rests, prospect theory is the other. Like mental accounting, prospect theory deals with the way we frame decisions, the different ways we label—or code—outcomes, and how they affect our attitude toward taking risks.

Instead we’ve divided the ramifications of prospect theory—and the inconsistent way people treat losses and gains—into a pair of basic concepts. The first, which we’ll discuss in this chapter, is the way that our feelings about loss (called “loss aversion” in behavioral economics lingo) and our inability to forget money that’s already been spent (the “sunk cost fallacy”) make us too ready to throw good money after bad. In the next chapter, we’ll explore the second concept: how a preference for keeping things the way they are (the “status quo bias”) combines with a tendency to fall in love with what we own (the “endowment effect”) to make us resist change. A deeper understanding of both concepts should lead you to better investment and spending decisions.

In financial matters this phenomenon results in a willingness to take more risk if it means avoiding a sure loss and to be more conservative when given the chance to lock in a sure gain.