Prospect theory and entrepreneurship
Prospect Theory: Why Founders Fear Loss More Than They Value Gain
Why do some entrepreneurs take reckless risks while others play it too safe? The answer often lies in Prospect Theory.
Developed by Nobel Prize-winning psychologists Daniel Kahneman and Amos Tversky in the 1970s, this behavioral economic theory changed how we understand decision-making. Its most famous hypothesis is Loss Aversion: the psychological pain of losing is about twice as powerful as the pleasure of gaining.
The Two "Frames" of Risk
The theory posits that humans are not rational calculators. Instead, our risk tolerance changes entirely based on whether we feel like we are currently "winning" or "losing."
- The Gain Domain (Winning): When individuals think they are ahead, they become Risk-Averse. They want to protect what they have won.
- The Loss Domain (Losing): When individuals think they are behind, they become Risk-Seeking. They are inclined to take bigger, bolder risks to get back to a "break-even" position.
As illustrated in the graph above, the "Loss" curve is much steeper than the "Gain" curve. This explains why the pain of a $10,000 loss feels much worse than the happiness of a $10,000 profit.
Application to Entrepreneurship
Hsu et al. (2017) applied this to founders, noting that a person's "frame" influences their attitude toward re-entering entrepreneurship.
Entrepreneurs judge their position based on a Reference Point (usually their previous venture). This leads to two fascinating behaviors:
1. The Failed Entrepreneur (Risk Seeking)
An entrepreneur who has failed previously often interprets themselves as being in a "loss position." Desperate to get back to zero (break-even), they may take outsized risks. They are "chasing their losses," much like a gambler trying to win back money.
2. The Successful Entrepreneur (Risk Averse)
Conversely, an entrepreneur with high income or a previous exit views themselves as being in a "gain position." According to the theory, they may subsequently take fewer risks to protect their status and wealth, potentially missing out on disruptive innovation.
Beyond Financial Reference Points
It’s not always about money. Busenitz et al. (2003) suggest that entrepreneurs might use psychological reference points, such as Autonomy.
If an entrepreneur feels they are losing their freedom (e.g., taking orders from a VC board), they enter a "Loss Frame" regarding their autonomy. This might explain why they take bold, sometimes irrational actions to regain control, even if it hurts the business financially.
This theory is highly related to the Regulatory Focus Theory of Entrepreneurship.
Video: Kahneman on Thinking, Fast and Slow
References
Busenitz, L. W., et al. (2003). Entrepreneurship research in emergence: Past trends and future directions. Journal of Management, 29(3), 285-308.
Hsu, D. K., Wiklund, J., & Cotton, R. D. (2017). Success, failure, and entrepreneurial reentry: An experimental assessment of the veracity of self‐efficacy and prospect theory. Entrepreneurship Theory and Practice, 41(1), 19-47.
Tversky, A., & Kahneman, D. (1986). Rational choice and the framing of decisions. Journal of Business, 59(4), S251-S278.
