Prospect Theory
Prospect Theory is a behavioral economic model developed by Daniel Kahneman and Amos Tversky that describes how people actually evaluate outcomes under uncertainty, using an S-shaped value function that weights losses more heavily than equivalent gains.
Prospect Theory was introduced in Kahneman and Tversky's 1979 paper in Econometrica — one of the most cited academic papers in economics — as a descriptive alternative to Expected Utility Theory. While Expected Utility Theory predicts that people evaluate risky outcomes based on final wealth levels and consistent probability weighting, Prospect Theory demonstrates that actual human choices systematically deviate from those predictions in ways that are predictable and stable.
The theory has three core components. First, outcomes are evaluated relative to a reference point — typically the status quo or the purchase price — rather than in absolute wealth terms. Gains and losses are measured from that reference, not from zero. Second, the value function is concave in the domain of gains (diminishing sensitivity to additional gains) and convex in the domain of losses (diminishing sensitivity to additional losses), producing the characteristic S-shape. Third, and most importantly, the function is steeper in the loss domain than in the gain domain, capturing loss aversion — the finding that losses hurt roughly twice as much as equivalent gains feel good.
A fourth component, probability weighting, shows that people overweight small probabilities (explaining why lotteries and catastrophe insurance are simultaneously popular) and underweight moderate-to-high probabilities. This distortion produces risk-seeking behavior in the loss domain — investors take large risks to avoid locking in a loss — and risk-aversion in the gain domain — investors sell winners quickly to preserve gains.
Prospect Theory underpins many other behavioral finance concepts: loss aversion, the disposition effect, mental accounting, and the equity risk premium puzzle all find partial explanation in its framework. Kahneman's solo Nobel Prize in Economics in 2002 (Tversky had died in 1996) recognized this body of work as transformative for understanding economic decision-making.
For investors, Prospect Theory is not merely descriptive — it is diagnostic. Recognizing which part of the S-shaped value function is governing a decision at any given moment allows for deliberate recalibration toward rational expected value maximization.