Prospect theory

Standard finance assumes people judge a risky choice by its expected outcome for their total wealth. Prospect theory, introduced by Daniel Kahneman and Amos Tversky in 1979, describes how people actually decide.

The workbook summarises its three premises:

1. Choices are evaluated relative to a reference point (the person's current well-being), not in terms of final wealth.
2. People are risk-averse about gains — they lock them in early — but risk-seeking about losses — they hold on to them longer.
3. Monetary losses hurt more than monetary gains.

Kahneman's 2002 Nobel prize, and Richard Thaler's in 2017, are what the workbook credits for bringing behavioural finance to the forefront.

Prospect theory describes choice in two phases:

1. Framing (editing). Prospects are framed, using heuristics to do a preliminary analysis. How a choice is presented shapes how it is perceived.
2. Evaluation. The edited prospects are evaluated and the one with the highest perceived value is chosen.

The theory therefore covers three things, in the workbook's words: how prospects are perceived based on their framing, how gains and losses are evaluated, and how uncertain outcomes are weighted.

It underpins several biases the workbook lists separately. Loss aversion (losses are more powerful than gains) and the disposition effect (selling winners early, holding losers too long) follow directly from premises 2 and 3. Framing bias follows from phase 1 — and the workbook warns that framing matters when an investor fills in a risk tolerance questionnaire, because it will shape the asset allocation.

Illustrative figures. A portfolio manager puts two questions to a client, Suresh, during onboarding.

Question 1 — a gain.

• A: receive ₹50,000 for certain.
• B: a 50% chance of ₹1,00,000, 50% chance of nothing.

Suresh chooses A. Expected value is ₹50,000 either way — he is risk-averse in gains.

Question 2 — a loss.

• C: lose ₹50,000 for certain.
• D: a 50% chance of losing ₹1,00,000, 50% chance of losing nothing.

Suresh chooses D. Expected value is −₹50,000 either way — he is risk-seeking in losses.

Nothing about his wealth changed between the two questions; only the reference point and the framing did. In his real portfolio the same pattern appears as selling a stock up ₹40,000 to "book the profit" while refusing to sell one down ₹60,000 in the hope of getting back to even.

The manager's lesson from the workbook: a risk questionnaire that frames outcomes as losses will record a different risk appetite from one that frames the same outcomes as gains.

Chapter 14 (Behavioural Finance), section 14.2.2, sets out prospect theory, its two phases and its three premises; the section on framing bias refers back to it. Two Chapter 14 sample questions test it directly — who introduced it (Kahneman and Tversky, 1979) and which statements are its premises (all three).

• Kahneman and Tversky, 1979. Bounded rationality is Herbert Simon; mental accounting is Richard Thaler.
• Risk-averse in gains, risk-seeking in losses — not the other way round.
• Two phases: framing first, evaluation second.
• Reference point, not final wealth. The same outcome can register as a gain or a loss depending on where the person starts.
• Prospect theory is the framework; loss aversion, the disposition effect and framing bias are specific biases the workbook discusses separately under emotional and cognitive categories.