Prospect Theory and Loss Aversion

Prospect Theory and loss aversion (Prospect Theory, Kahneman & Tversky) is an alternative to expected utility theory. It describes how people actually make decisions under risk.

Key elements
Reference dependence: assessment of outcomes relative to a reference point, not in absolute terms.
Loss aversion: losses "hurt" more than equivalent gains. Coefficient ~2:1.
Diminishing sensitivity: sensitivity to changes decreases as you move away from the reference point.
Probability weighting: overestimation of small probabilities, underestimation of large ones.

Value Function
S-shaped:
Convex for losses (risk-seeking in losses)
Concave for gains (risk-averse in gains)
Steeper for losses (loss aversion)

Consequences
Endowment effect: we value what we own higher than the equivalent, but not ours.
Status quo bias: preference for the current state.
Disposition effect: we sell winners too early and hold losers for too long.

For the investor
Avoid disposition effect: decisions about selling should be forward-looking.
Reference points: be aware of the influence of the "purchase price" on decisions.
Framing: how information is presented affects the decision.