Prospect Theory
A model of decision-making under risk in which outcomes are valued as gains and losses from a reference point, with losses weighted more heavily.
How it is identified
Value function: concave for gains, convex for losses, and steeper for losses than for gains by a factor of roughly two
Unit
qualitative
In depth
Kahneman and Tversky's theory replaced the assumption that people maximise expected wealth with the observation that they evaluate changes relative to a reference point — usually the purchase price. Its three components are reference dependence, loss aversion, and probability weighting, under which people overweight small probabilities and underweight large ones. The asymmetry produces risk aversion when facing gains and risk seeking when facing losses, which is exactly backwards for good investing: it makes people take profits early and gamble on recovery. Nearly every bias in this category traces back to some part of this structure.
Worked example
Offered a certain ₹50,000 gain or a coin flip for ₹1,00,000, most people take the certain gain. Facing a certain ₹50,000 loss or a coin flip for ₹1,00,000, most take the flip — the same arithmetic, opposite choices.
Illustrative figures, chosen so the arithmetic is easy to follow. Not a live price and not a valuation of any company.
Educational reference only
This entry explains what “Prospect Theory” means. It is not investment advice and not a recommendation to buy or sell any security. Any numbers above are illustrative, not live prices, and nothing here predicts price direction or rates a stock. Consider your own circumstances and consult a SEBI-registered investment adviser before acting.