Prospect theory is the model of how people actually make decisions under risk — as opposed to how a perfectly rational calculator would. Kahneman and Tversky introduced it in 1979. Its core insight: people judge changes — gains and losses relative to a reference point — not final wealth, and they feel losses far more sharply than equal gains.
1. Losses hurt about twice as much as gains feel good. This is loss aversion, and it is why a drop feels worse than an equal-sized gain feels good. 2. We measure from a reference point — usually the purchase price, so you feel "up" or "down" relative to what you paid, not relative to what the stock is worth today. 3. We take the wrong risks: people become risk-averse on a gain (grabbing a small profit early) but risk-seeking on a loss (holding, or adding, to avoid crystallising the pain). That pattern is the disposition effect: selling winners too soon and holding losers too long.
Example (illustrative): you own two stocks, one up 15% and one down 15%. Prospect theory predicts the urge to sell the winner (lock in the good feeling) and keep the loser (avoid admitting the loss) — usually the reverse of what a cold look at each company's prospects would tell you to do.
Prospect theory is a map of the predictable ways your own wiring pushes you toward bad exits. The defence is to make the emotional decisions in advance and in writing, when no money is on the line: a take-profit and stop-loss plan and a pre-set invalidation level decide when to sell before the gain-or-loss feeling can distort the choice. Recognising that your cost basis is just a reference point, not a fact about value, is half the battle.
It is the model of how people really make risky decisions: we judge gains and losses against a reference point, feel losses roughly twice as sharply as equal gains, and take the wrong risks as a result.
Loss aversion — feeling losses more than equivalent gains — is one of prospect theory's core components, along with the reference point and the tendency to hold losers but sell winners (the disposition effect).
It predicts the exact mistakes your emotions push you toward, so the defence is to set take-profit, stop-loss, and invalidation levels in advance, before the gain-or-loss feeling distorts the decision.
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Educational research only — not investment advice.