Reference point

Standard finance assumes people judge outcomes by their effect on total wealth. Prospect Theory, introduced by Daniel Kahneman and Amos Tversky in 1979, says something different: people evaluate choices relative to a reference point, which the workbook describes simply as their well-being.

What counts as a gain or a loss, in other words, is not fixed by the numbers alone — it depends entirely on where the reference point sits.

The workbook sets out Prospect Theory's decision process in 2 phases: an early framing phase, in which prospects are set up against a reference point using quick heuristics, and a later evaluation phase, in which the framed prospects are weighed and the one with the highest perceived value is chosen.

Once the reference point is fixed, the workbook's other two Prospect Theory premises follow from it: people are risk-averse about gains — they prefer to realise a gain early rather than risk it — but risk-seeking about losses — they prefer to hold on to a loss longer, hoping it reverses, rather than realise it. And monetary losses hurt more than equivalent monetary gains please — the same rupee amount is felt asymmetrically depending on which side of the reference point it falls.

Illustrative figures. Mr Sethi bought a stock at Rs 500. Its price is now Rs 600.

His natural reference point is his Rs 500 purchase price, so he frames the current position as a Rs 100 gain, and Prospect Theory predicts he is inclined to book it — sell and realise the gain — rather than risk giving it back.

Now consider Mrs Kapadia, who bought the same stock at Rs 750 and watches it sit at Rs 600. Her reference point is her own Rs 750 cost, so the identical Rs 600 price is framed as a Rs 150 loss for her. Prospect Theory predicts she is inclined to hold on, hoping to get back to her reference point, rather than realise the loss — the same market price, evaluated from two different reference points, producing opposite investor behaviour.

Chapter 16 (Basics of Behavioural Finance), section 16.2.2, "Prospect Theory," lists reference point as the first of the theory's three summary premises, alongside risk-aversion for gains and loss aversion. Expect a module-end question, reproduced in the workbook itself, that lists the Prospect Theory premises and asks which one describes the reference point.

• The reference point is not necessarily the purchase price — the workbook describes it generally as the investor's own sense of well-being, which purchase price often anchors but does not always define.
• Risk-averse for gains, risk-seeking for losses is the direct consequence of the reference point, not a separate, unrelated bias. A question may test whether the candidate can connect the two.
• This premise is part of Prospect Theory specifically, introduced by Kahneman and Tversky in 1979 — do not attribute it to Herbert Simon's Bounded Rationality, a different concept from the same chapter.