Prospect Theory
Prospect theory is Kahneman and Tversky’s model of choices under risk — people weigh losses harder than gains and distort probabilities.
Definition
Prospect Theory refers to people weigh losses harder than gains and distort probabilities. Keep that definition fixed when comparing series, managers, or regimes — renaming the same tape does not create a new signal.
Why it matters
It shows up in factor research, attribution, and capacity debates — whether a return slice is skill, style, or fee drag. When people weigh losses harder than gains and distort probabilities shifts, related hedges, limits, and narratives usually need an explicit update rather than a quiet assumption.
Case
Suppose a desk is positioned for the opposite of what prospect theory is saying. If people weigh losses harder than gains and distort probabilities moves against that book, the first question is not “is the story clever?” but whether size, hedges, and stop logic still match the observation.
How to read it
Check definition stability across universes, costs, and regimes before treating a backtest as portable. Prefer a short written null hypothesis for Prospect Theory: what would falsify the current reading in the next window?