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What is Prospect Theory?
Prospect Theory, developed by Daniel Kahneman and Amos Tversky (1979 paper in Econometrica; Kahneman's 2002 Nobel Prize), describes how humans actually evaluate risky choices — contrary to the rational "expected utility" model of classical economics. It is the empirical foundation of behavioural finance.
The S-Shaped Value Function
Investors evaluate outcomes as gains and losses relative to a reference point (purchase price, previous portfolio peak), not in terms of absolute final wealth. The value function plotted against gain/loss is S-shaped:
- Concave in gains — each extra rupee earned feels less exciting (diminishing marginal utility)
- Convex in losses — each extra rupee lost hurts less than the first (you go numb)
- Steeper on the loss side — the curve drops sharply below the reference point
Loss vs Gain Asymmetry (Loss Aversion)
Empirically, the pain of losing Rs 100 is about 2 to 2.5x more intense than the pleasure of gaining Rs 100. This is the loss aversion coefficient. It explains why investors hold losing stocks too long (refusing to "realize" the loss) and sell winners too early (locking in the dopamine of a gain) — the classic disposition effect.
Worked Indian Example
An investor buys an IT stock at Rs 1,000. It drops to Rs 700. Prospect theory predicts they will refuse to sell and accept the Rs 300 loss — even when fundamentals have deteriorated and a Rs 850 alternative offers better expected return. Conversely, the same investor sells a winner up 30% prematurely because gain-concavity makes further upside feel small.
Probability Weighting
Prospect theory's second pillar: investors overweight small probabilities (overpaying for OTM options and lottery-like microcaps) and underweight moderate probabilities (ignoring boring 70%-success outcomes like index funds).
When to Apply (Defensive Use)
- Set sell rules before a position moves into loss territory — pre-commitment beats in-the-moment willpower
- Re-anchor mentally on intrinsic value, not purchase price
- Beware lottery-style microcaps and binary biotech bets — you're paying a behavioural premium
Educational only — not advice. ARN-314872.