Prospect Theory is a groundbreaking model in Behavioral Economics that describes how real people actually make decisions when faced with risk and uncertainty. Developed by the psychologists Daniel Kahneman and Amos Tversky in 1979, it shattered the classical economic assumption that we are all perfectly rational decision-makers. Instead of evaluating choices based on the final outcome of our total wealth (as suggested by the older Expected Utility Theory), we tend to think in terms of potential gains and losses relative to a specific starting point. The theory reveals that our emotional response to a loss is far more intense than our response to an equivalent gain, and that our risk tolerance changes dramatically depending on whether we are facing a potential profit or a potential loss. For investors, understanding these psychological quirks is the first step toward overcoming them and making more rational, profitable decisions.
Prospect theory is built on a few simple but powerful observations about human psychology.
Let's be honest: losing $100 feels much worse than gaining $100 feels good. This is the essence of Loss Aversion. Kahneman and Tversky’s research suggests that, psychologically, the pain of a loss is roughly twice as powerful as the pleasure of a gain. Picture this: someone offers you a coin flip.
Even though the potential gain is larger than the potential loss, most people will turn down this bet. The fear of losing that $100 outweighs the allure of winning $150. This simple bias has huge implications for investors, who often make irrational choices to avoid realizing a loss, even when it’s the financially prudent thing to do.
Prospect theory argues that we don't think in terms of absolute wealth. Instead, we evaluate outcomes based on a Reference Point, which is usually our current status quo or an initial starting point. For an investor, the most common reference point is the purchase price of a stock. If you buy a stock at $50, and it drops to $40, you see a $10 loss. If it then climbs to $60, you see a $10 gain. The final price of $60 is the same, but your feelings about it are framed entirely by your purchase price. An investor who bought the same stock at $70 would feel miserable at $60, viewing it as a painful loss. This is why two people can look at the same stock price and have completely different emotional reactions. The “facts” are the same, but their reference points are different.
The impact of a change in wealth diminishes the further it moves from our reference point. The difference between gaining $0 and gaining $100 feels enormous. But the difference between gaining $1,000 and gaining $1,100 feels much less significant, even though the absolute gain is the same ($100). The same is true for losses. The pain of your first $100 loss on an investment is acute. The pain of losing another $100 after you’re already down $1,000 is still there, but it doesn't sting quite as much. This leads to some strange risk-taking behavior, especially when we're in the red.
Understanding these mental shortcuts is not just an academic exercise. They directly lead to costly investment mistakes.
The Disposition Effect is prospect theory in action. It's the tendency for investors to sell stocks that have gone up in price (to lock in a sure, pleasant gain) while holding on to stocks that have gone down (to avoid the certain pain of a loss). This is the exact opposite of the age-old wisdom to “cut your losses and let your winners run.” By clinging to losers, investors hope for a rebound that will get them back to their break-even reference point. This often means they throw good money after bad, while simultaneously cutting off their most successful investments before they have a chance to truly compound.
Because we think in terms of gains and losses from a reference point, how a choice is presented (the Framing Effect) can dramatically change our decision. Consider two ways to describe a medical treatment:
The information is identical, but the frame—gains (survival) versus losses (mortality)—triggers a different emotional response. In investing, a stock “up 20% from its 52-week low” sounds far more appealing than the same stock being “down 50% from its 52-week high.” Be wary of how information is framed, whether by financial news, a company's management, or even your own internal monologue.
Here's the most dangerous trap of all. While we are generally risk-averse when it comes to gains (we'd rather take a sure $500 than a 50/50 shot at $1,000), prospect theory shows we become risk-seeking when facing losses. If an investor is down significantly on a stock, they face a choice: sell now and accept a certain, painful loss, or hold on (or even buy more) for a chance to break even. The desire to avoid the pain of a sure loss is so strong that many will take the gamble, even if it's a terrible one. This is how a small, manageable loss can spiral into a catastrophic one.
As a Value Investing practitioner, your goal is to be rational when others are emotional. Prospect theory gives you the map of their emotional minefield. Here's how to navigate it: