Prospect Theory is the behavioral economics framework developed by Daniel Kahneman and Amos Tversky (1979) that describes how people actually make decisions under uncertainty — as opposed to how rational economic theory predicts they should. The theory’s central insight is that people evaluate outcomes relative to a reference point (typically the status quo), feel the pain of losses approximately twice as intensely as the pleasure of equivalent gains, and apply non-linear probability weights that overweight small probabilities and underweight large ones.

The Value Function

Prospect Theory’s value function is asymmetric and concave in the domain of gains (diminishing marginal utility as gains increase) and convex in the domain of losses (diminishing sensitivity as losses deepen). This shape has direct investment implications: investors are risk-averse in the domain of gains (preferring a certain smaller gain to a larger uncertain one) but risk-seeking in the domain of losses (preferring a risky chance of recovering a loss over accepting a certain smaller loss). This reversal of risk preferences is responsible for several classic investment errors.

Investment Implications of Prospect Theory

Prospect Theory explains several pervasive investment mistakes. The disposition effect — the tendency to sell winners too early (risk aversion in the gain domain) and hold losers too long (risk seeking in the loss domain) — is a direct prediction of Prospect Theory that has been confirmed empirically across individual and professional investors. This is the behavioral opposite of optimal trading: it means investors lock in gains before they can run and refuse to accept losses before they compound. Systematic investment rules that force consistent exit behavior regardless of the gain/loss status of a position directly counteract this Prospect Theory-driven tendency.

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