What Is Prospect Theory
Have you ever felt that, for the same amount of about $74, the pain of losing it was far greater than the joy of gaining it? The first to explain this asymmetry with mathematics was prospect theory.
Where Prospect Theory Came From
Prospect Theory is a decision-making theory published by psychologists Daniel Kahneman and Amos Tversky in the economics journal Econometrica in 1979. Kahneman received the 2002 Nobel Prize in Economics for research that included this contribution.
Until then, economics assumed that people coolly calculate 'expected utility' and choose rationally. Prospect theory revolted against this, showing that real people judge not by 'the absolute amount of an outcome' but by the change of 'how much they gained or lost from a reference point.'
Three Core Ideas: Reference Point, Loss Aversion, S-Curve
(1) Reference dependence: People feel satisfaction not from their final level of wealth but from 'gains and losses relative to a reference point (usually the current state or purchase price).' The same about $74,000 feels completely different whether it came down from about $148,000 or came up from about $37,000.
(2) Loss aversion: For the same magnitude, the pain of a loss is far greater than the joy of a gain. Across many experiments, this ratio (λ) is roughly 1.5–2.5, and the frequently cited representative value is about 2. In other words, it's summarized as 'a loss hurts about twice as much as a gain.'
(3) S-shaped value function: In the gain domain it is concave, so as gains grow the thrill dulls; in the loss domain it is convex, producing a tendency to take on risk in the loss region.
The loss-aversion coefficient λ has a wide range depending on experimental design and measurement method. Here it is noted as the frequently cited 'about 1.5–2.5, roughly double.' Do not take any specific value as an absolute constant.
How It Shows Up in Investing
Prospect theory explains the roots of many investing mistakes.
Risen stocks are in the gain region, so you want to avoid risk and sell quickly (the disposition effect); fallen stocks are in the loss region, so you take on risk and hold on 'until you get back to even.' You also get trapped by the reference point of the purchase price, judging by 'what price you bought at' rather than 'the outlook from here.'
When loss aversion is strong, the pain amplifies in down markets, making it easy to dump at the bottom. This is exactly why this project always shows the maximum drawdown and the duration of losses alongside returns. You need to know in advance the size of loss you can endure in order to hold through that stretch.
Preguntas frecuentes
Q. What is the biggest difference between prospect theory and expected utility theory?
Expected utility theory holds that people calculate rationally based on 'total final wealth.' Prospect theory holds that people judge by the relative change of 'gains and losses relative to a reference point,' feel losses more than gains (loss aversion), and take different risk attitudes in the gain and loss regions. The core is that it explains real people's choices far better.
Q. Is there a way to overcome loss aversion?
You can't eliminate it completely, but you can reduce it. Not checking your account too often, judging by 'the outlook for this asset now' rather than the purchase price, and allocating assets within a drawdown range you can endure in the first place all help. Knowing that the bias exists is itself the first line of defense.
Páginas relacionadas
📋 Los resultados se basan en datos históricos; las rentabilidades pasadas no garantizan rentabilidades futuras.
📋 Este servicio se ofrece con fines educativos para ayudarte a entender la inversión, no como asesoramiento de inversión.