Prospect Theory
Prospect Theory, developed by Daniel Kahneman and Amos Tversky and published in 1979, described how individuals evaluated probabilistic outcomes relative to a reference point rather than in absolute terms, placing approximately 2.5 times greater weight on losses than equivalent gains — a framework that explained numerous observed investor behaviours including the disposition effect and reluctance to stop SIPs during drawdowns.
The central departure of Prospect Theory from expected utility theory was the S-shaped value function. In the gains domain, the function was concave — meaning marginal satisfaction from additional gains diminished, producing risk-aversion in the gains domain. In the losses domain, the function was convex — meaning marginal pain from additional losses diminished at the margin, producing risk-seeking behaviour in the loss domain. The function was steeper in the loss domain than the gain domain, capturing loss aversion: a loss of Rs 10,000 hurt approximately 2-2.5 times as much as a gain of Rs 10,000 produced satisfaction.
Prospect Theory also introduced the probability weighting function, which showed that individuals overweighted small probabilities (explaining the appeal of lottery tickets and insurance for catastrophic but rare events) and underweighted moderate-to-high probabilities. In an investing context, this contributed to the popularity of F&O strategies that offered small premiums with large downside tail risk — retail option sellers who collected small premiums while being exposed to large, low-probability losses were behaving consistently with this weighting pattern.
The disposition effect — the tendency to sell winning positions too quickly and hold losing positions too long — was directly predicted by Prospect Theory. In the gains domain, risk aversion led investors to lock in profits before they reversed. In the loss domain, risk-seeking led investors to hold on, hoping to avoid realising the loss. Indian market research using NSE demat account data documented the disposition effect in domestic retail portfolios, with loss-making positions held for significantly longer durations than gain-making positions on average.
For SIP investors, loss aversion explained a destructive pattern: pausing or stopping SIPs precisely when markets fell, which eliminated the rupee-cost-averaging benefit that SIP was designed to deliver. AMFI data showed SIP pause rates rising during periods of market stress — March 2020 was a prominent example — before recovering as markets recovered, meaning retail investors systematically reduced equity exposure at the lowest prices and effectively re-entered at higher costs.
Framing effects — another Prospect Theory prediction — explained why the same investment outcome presented differently produced different decisions. Rs 5 lakh portfolio falling to Rs 4 lakh (loss frame) felt far worse than describing the same portfolio as having 80% of value intact (gain frame), even though the economic situation was identical. Financial product marketing exploited framing extensively, which SEBI addressed through standardised performance disclosure requirements.