Kahneman and Tversky's model of how people actually evaluate gains and losses — showing that outcomes are evaluated relative to a reference point, and losses are weighted more heavily than equivalent gains.
“The idea that our decisions are based on an evaluation of gains and losses relative to a reference point was the central finding.”
— Daniel Kahneman
Deeper Explanation
Prospect Theory, published by Kahneman and Tversky in 1979, is the foundational paper of behavioural economics. It replaced the expected utility framework of classical economics — which assumed people evaluate outcomes rationally based on absolute wealth levels — with a descriptive model of how people actually behave. The theory has three core propositions. First, reference dependence: people evaluate outcomes relative to a reference point (typically the status quo or the purchase price), not in absolute terms. A £1,000 gain is evaluated as a gain — positive relative to the reference — regardless of whether the starting wealth is £10,000 or £1,000,000. Second, loss aversion: losses feel approximately twice as painful as equivalent gains feel pleasurable, creating an asymmetric value function. Third, diminishing sensitivity: both gains and losses show diminishing sensitivity as they grow larger — the difference between gaining £100 and £200 feels larger than the difference between gaining £1,000 and £1,100. These three properties together generate specific, testable predictions about behaviour that violate classical expected utility theory. People are risk-averse in the domain of gains (they prefer a certain £100 to a 50% chance of £200) but risk-seeking in the domain of losses (they prefer a 50% chance of losing £200 to a certain loss of £100). This "reflection effect" is one of the most consistently replicated findings in behavioural economics. For investors, Prospect Theory's most important implication is the disposition effect: because gains feel "safe" and losses feel like they must be recovered, investors systematically sell winners (risk-aversion in gains domain) and hold losers (risk-seeking in losses domain). This is the opposite of what evidence-based portfolio management suggests.
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