Prospect Theory
Prospect theory is Kahneman and Tversky’s model of choices under risk — people weigh losses harder than gains and distort probabilities.
Definition
Value is defined on gains and losses versus a reference, not on final wealth. The value function is concave over gains, convex over losses, and steeper for losses (loss aversion). Probability weighting overweights tails.
Why it matters
It is the standard explanation for disposition effect, insurance-plus-lottery demand, and some of the vol-selling / crash-put coexistence.
Case
Investors sell winners too early and hold losers too long. The reference point was the purchase price, not the DCF.
How to read it
Name the reference point. Without it, ‘behavioral’ is a shrug. Then ask whether the flow is large enough to move the price.
Key papers
Landmark references with real publisher or arXiv links — not token-overlap noise.
- Prospect Theory: An Analysis of Decision under RiskKahneman, Tversky · 1979 · EconometricaThe original prospect-theory paper.