Definition
Prospect Theory
Prospect theory, developed by Kahneman and Tversky, describes how people actually evaluate risky choices — judging outcomes as gains or losses from a reference point rather than in terms of final wealth.
The theory has two big ideas. First, value is felt relative to a reference point (usually your purchase price or current position), not in absolute terms. Second, the value curve is steeper for losses than gains — the basis of loss aversion — and people are risk-averse over gains but risk-seeking over losses, which is why someone sitting on a loss will 'double down' to avoid realising it.
Prospect theory also captures how we distort probabilities, overweighting tiny chances (why lottery tickets and lottery-like small-cap bets sell) and underweighting near-certainties. For an Indian investor it explains chasing a multibagger tip while ignoring a steady SIP. The practical lesson is to anchor decisions to your goals and asset allocation, not to the running gain or loss on a single holding.
Related terms
- Loss AversionLoss aversion is the well-documented tendency for the pain of a loss to feel roughly twice as powerful as the pleasure of an equivalent gain.
- Mental AccountingMental accounting is the tendency to treat money differently depending on its source or label, instead of recognising that all money is fungible.
- Framing EffectThe framing effect is the way the same financial information leads to different decisions depending on how it is presented or 'framed'.
Plain-English explainer from The Dispatch Investors Encyclopedia. General information, not financial advice.