16.7 : The Prospect Theory

Prospect theory, developed by Daniel Kahneman and Amos Tversky, explains how individuals make decisions under risk and uncertainty, particularly in the context of investments. Unlike traditional economic theories that assume investors act rationally to maximize utility, prospect theory suggests that people evaluate potential gains and losses relative to a reference point rather than in absolute terms.

Loss Aversion and Its Impact on Decision-Making

A central tenet of prospect theory is loss aversion, which states that the pain of losing is psychologically more significant than the pleasure of an equivalent gain. Empirical studies demonstrate that individuals typically weigh losses about twice as heavily as gains of the same magnitude. This asymmetry influences investment behavior, making investors more likely to hold on to losing stocks in hopes of breaking even, a behavior known as the disposition effect, while quickly selling winning stocks to lock in gains.

The Value Function in Prospect Theory

Prospect theory introduces a value function that is concave for gains and convex for losses. This function illustrates diminishing sensitivity, where individuals perceive incremental changes differently based on their reference point. For gains, the curve is concave, indicating risk aversion—investors prefer a smaller, guaranteed gain over a potentially larger but uncertain reward. Conversely, the function is convex for losses, meaning individuals are more inclined to take risks to avoid further loss. The steeper slope for losses quantifies the greater emotional impact of losses compared to gains, reinforcing the concept of loss aversion.

Implications for Investment Strategies

Understanding prospect theory can help investors mitigate behavioral biases and make more rational financial decisions. Awareness of loss aversion can encourage diversification and systematic investment strategies rather than emotional reactions to market fluctuations. Additionally, by setting realistic reference points and employing disciplined risk management techniques, investors can improve decision-making processes and enhance long-term financial outcomes.