Who it's for — Anyone who wants to understand why traders and investors don't behave like «rational utility» maximizers — and why loss, gain, and framing change choices.
Prospect theory describes how people evaluate potential outcomes relative to a reference point (often entry price or break-even): concave on gains, convex on losses, with marked loss aversion. A pillar of behavioural finance, it explains many operational biases in trading.
In plain terms — We are not neutral calculators: the pain of losing drives more choices than the pleasure of an equal gain. And we evaluate everything relative to «where I started».
Key concepts
| Element | Trading implication |
|---|---|
| Reference point | Break-even, average price, last high |
| Loss aversion | Hold losers, cut winners early |
| Certainty vs risk | Prefer small sure gain |
| Framing | Same P&L, different reaction if «in profit» or «in loss» |
Prospect theory links to mental accounting (mental capital compartments) and crowd biases like herding.
Common mistake — Managing the same trade differently only because you are «below» or «above» entry — the market does not know where you bought.
Example — Long from 100, price 98: you refuse stop «to avoid closing at a loss». At 102 you'd take profit immediately — typical prospect + loss aversion asymmetry.
Summary card
- What it is: non-rational risk decision model.
- Core: reference point, loss aversion, value curve.
- Hub: Trading psychology.