The Paper That Changed Economics
In 1979, Daniel Kahneman and Amos Tversky published "Prospect Theory: An Analysis of Decision Under Risk" in Econometrica. It is one of the most cited papers in the history of economics and the founding document of behavioural finance. Before it, the dominant model of human decision-making was expected utility theory — the idea that rational agents choose options that maximise their expected utility, evaluated in terms of total wealth. Kahneman and Tversky showed, through systematic experiments, that this is not how people actually behave.
Evaluating Outcomes Relative to a Reference Point
The first key finding of prospect theory is that people evaluate outcomes relative to a reference point, not in absolute terms. The reference point is usually the status quo — the price you paid for an investment, your account balance last month, or whatever you consider the "neutral" outcome. A gain of £500 feels like a gain if your reference point is £0, but like a loss if your reference point was an expectation of £1,000. Rational expected utility theory says this cannot matter — only total wealth should affect decisions. Prospect theory says it matters enormously.
The S-Shaped Value Function
Kahneman and Tversky described a characteristic S-shaped value function. In the gains domain (outcomes above the reference point), the value function is concave: each additional pound of gain feels less significant than the last. Going from £0 to £100 feels better than going from £100 to £200. This is diminishing sensitivity to gains. In the losses domain (outcomes below the reference point), the value function is convex: each additional pound of loss also feels progressively less painful than the last. But — critically — the loss side of the function is steeper than the gain side.
Loss Aversion: The Asymmetry
The steeper loss side captures loss aversion: losses loom larger than equivalent gains. Kahneman and Tversky estimated the pain of a loss at roughly twice the pleasure of an equivalent gain. Losing £100 feels approximately twice as bad as gaining £100 feels good. This asymmetry has profound implications for investment decisions — it helps explain why investors behave in ways that hurt them, from holding losing positions too long to selling winning ones too soon.
Why This Differs From Rational Theory
Expected utility theory predicts that a rational investor should be willing to accept a 50/50 bet of losing £100 or gaining £100 — it is a fair bet, and in terms of expected value, it should be neutral. In practice, most people refuse such bets, requiring a gain of around £200 to compensate for the risk of losing £100. They are not evaluating total wealth; they are feeling the asymmetric pull of potential loss. Kahneman won the 2002 Nobel Prize in Economics for this body of work.