How prospect theory explains the way people choose under risk

Older economic models assumed people always weigh risks in a neat, logical way. Prospect theory showed that real people do not. This page explains what prospect theory says, its key ideas and how it applies to investing.

Quick answer

Prospect theory is a model of how people make decisions when the outcome is uncertain. It was published by Daniel Kahneman and Amos Tversky in 1979. It says people judge outcomes as gains or losses from a reference point, feel losses more strongly than gains, and tend to overweight small chances. This explains many choices that classic theory cannot.

Key takeaways

• Prospect theory explains choices under risk.
• It was published by Kahneman and Tversky in 1979.
• People judge gains and losses from a reference point.
• Losses weigh more than equal gains.
• People tend to overweight small probabilities.

What is prospect theory?

It is a description of how people actually choose between risky options. Before it, the main model was expected utility theory, which assumed people calmly weigh each outcome by its probability and pick the option with the highest average result.

Kahneman and Tversky ran experiments and found that people often break those rules in predictable ways. Their 1979 paper in the journal Econometrica set out a new model. Kahneman later received the 2002 Nobel Prize in economics, partly for this work.

The key ideas of prospect theory

The reference point is often the price you paid or your current wealth. A share at Rs 500 feels like a gain if you bought at Rs 400 and a loss if you bought at Rs 600, even though the value is the same.

Diminishing sensitivity means the difference between a Rs 100 and Rs 200 loss feels larger than the difference between a Rs 10,100 and Rs 10,200 loss. This shapes how people take risks.

Gains and losses lead to different behaviour

When facing gains, people tend to be risk averse. They prefer a sure gain over a gamble with a slightly higher average payoff. This can lead to selling winning shares early.

When facing losses, people tend to become risk seeking. They may take a gamble to avoid a sure loss. This helps explain why some traders hold losing positions or take bigger bets after a loss.

How prospect theory applies to investing

It explains the disposition effect, where investors sell winners and hold losers. It also helps explain why assets with a small chance of a very large payoff can attract buyers, since small probabilities feel larger than they are.

Knowing these patterns can help you build rules that protect you from them, such as fixed stop losses and a plan for taking profits. It is a tool for understanding behaviour, not for predicting prices.

The key point to remember

Prospect theory is one of the foundations of behavioral finance. It shows that people judge risk based on gains, losses and feelings, not just on cold numbers.

Frequently Asked Questions