Prospect Theory: An Analysis of Decision under Risk
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What they found
Kahneman and Tversky showed with a series of simple choice experiments that people do not evaluate gambles by expected utility. Instead they judge outcomes as gains and losses relative to a reference point, feel losses roughly twice as strongly as equivalent gains (loss aversion), are risk-averse over gains but risk-seeking over losses, and overweight small probabilities while underweighting moderate ones. The resulting value function is concave for gains, convex for losses, and steeper for losses. This is the theoretical foundation for the disposition effect, lottery-stock preferences, and much of behavioral finance.
What you can use
- Losses hurt about twice as much as gains feel good, which is why cutting a loss feels so much harder than taking a profit.
- People become risk-seeking when losing, which is the psychology behind doubling down and revenge trading.
- Small probabilities are overweighted, so long-shot payoffs (lottery stocks, far OTM options) are systematically overpriced.
- Your reference point (usually entry price) shapes decisions that should depend only on the future.
Caveats
Based on hypothetical choices by students; the original model has technical issues fixed in cumulative prospect theory (1992). Parameters vary across people and contexts.
Tags: behavioral, prospect-theory, loss-aversion, foundations
Summaries are our own reading of the paper, not the authors' words. Educational only, not advice. Discuss it in Book Club.