Prospect Theory is a behavioral economic theory developed by Daniel Kahneman and Amos Tversky in the 1970s. It is explained in the Chartered Market Technicians curriculum for level 2.
The theory aims to explain how individuals make decisions under conditions of uncertainty and how they perceive gains and losses. Prospect theory deviates from classical economic theory, which assumes that individuals make rational decisions based on maximising expected utility. According to Prospect Theory, individuals evaluate outcomes relative to a reference point, often the status quo or their current situation, rather than in absolute terms. This can seem quite abstract, so let’s use an example.
The reference point explained
Suppose an investor purchases 100 shares of a company’s stock at $50 per share. After some time, the stock price increases to $70 per share. At this point, the investor’s reference point is the original purchase price of $50 per share. They have gained $20 per share, resulting in a paper profit of $2,000 (100 shares × $20 per share).
Now, let’s explore how Prospect Theory and the reference point come into play:
- Loss Aversion: According to prospect theory, the investor will likely feel the psychological impact of a potential loss more intensely. If the stock price starts to decline and reaches $60 per share, the investor is now facing a paper loss of $10 per share ($60 – $50), resulting in a total loss of $1,000 (100 shares × $10 per share). The investor may be inclined to take action to avoid or minimize the loss, as the pain of losing $1,000 may outweigh the objective probability of further declines.
- Value Function: The value function in Prospect Theory suggests that the investor’s perception of gains and losses is nonlinear. As the stock price moves away from the reference point of $50 per share, the marginal value of additional gains diminishes. For instance, the investor may not experience the same level of satisfaction or perceived utility from a subsequent $20 increase in the stock price ($70 to $90 per share) as he did from the initial $20 increase ($50 to $70 per share).
The reference point in this example is the original purchase price of $50 per share. It serves as a mental benchmark against which gains and losses are evaluated. There is an ’S’ shaper curve in terms of utility. The investor’s decision-making and emotional responses, such as holding onto the stock to avoid a loss or taking profits to secure gains, are influenced by this reference point.
This bias means that how often you check your assets means you can expose yourself more to loss aversion from seeing ‘paper losses’. More active investors are more vulnerable to this and passive investing means you are far less likely to experience loss aversion. ‘Loss aversion’ is essentially another risk premium that investors and traders need to be aware of.