Prospect theory suggests that investors are more concerned with potential losses than they are happy with potential gains. In other words, the negative feeling associated with investment losses outweighs the positive feeling associated with investment gains. Therefore, investors prefer avoiding investment losses more than they prefer investment gains.
Prospect theory was developed by Daniel Kahneman and Amos Tversky in the late 1970s and is a foundational work in behavioral finance. Prospect theory models how investors choose between alternatives involving risk and uncertainty and demonstrates the concept of loss-aversion. Prospect theory research has provided numerous insights into investors' psyche.
For example, investors respond differently to identical situations, depending on how the situation is proposed. Investors perceive the pain of a $1 loss to be twice as much as the pleasure of a $1 gain.
Prospect theory research expands beyond these examples and has important implications for investing. Loss aversion may drive investors to make suboptimal investment decisions. Even the frequency with which investors check their portfolios impacts investment decisions because of the psychological effect of unrealized gains and losses.
A famous example of prospect theory in action comes from Daniel Kahneman's experiment in Thinking Fast and Slow, where participants were given two sets of choices. Each choice set had the same expected value or ending amount of wealth but was framed differently. Behavior changed depending on the initial reference point and whether the set of choices were framed as a potential loss or gain.
Participants exhibited risk aversion and opted for a guaranteed gain when faced with a possible loss. However, they sought risk when faced with a certain loss but had the potential for a gain.