Prospect Theory

The theory was formulated in 1979 by Daniel Kahneman and Amos Tversky. Further, it was developed by them in 1992. It is the founding theory of behavioral finance and behavioral economics. Later in 2002, Kahneman won the Nobel Prize in Economic Sciences for his work in developing the “Prospect Theory“. By now you have realized the significance of the theory. Let’s take a deep dive to learn more.

The above graph explains the concept beautifully. The theory assumes that the same amount of loss and gain is valued differently. Thus we make decision based on perceived gains or losses instead of actual ones. Let’s take an example.

The end result of a task is receiving ₹5,000. You are given 2 options either take ₹5,000 in cash or gain ₹10,000 and lose ₹5,000. Which option will you choose? Assume any one option, before reading further. It is highly likely that you go with the first option. As the loss of ₹5,000 is way more emotionally attached to us. We can’t bear the pain of losing.

The same can be seen in investing where holding on to the losing stock is way easier than realizing the loss. As we still hope the prices will bounce back, without any rationality.

Let’s explore the last example for better understanding of the theory.

Let’s take two scenarios where the net result is losing hundred bucks. In first instance, you lose 1000 bucks initially and gain 900 bucks later. In second instance, you gain 900 initially and lose 1000 bucks later. Will your behavior will be same post the scenarios?

Since the net result is same, from distance it may appear that the resulting behavior must be same. However, in first instance you won 900 bucks at the end and we are more attached to the last actions. Hence, you are happier winning 900 bucks instead of losing 100 bucks. In second instance you lost 1000 bucks at the end. Hence, you are dejected at the loss of 1000 bucks.

Knowing one’s behavior is always helpful.

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Until then…