Prospect Theory Explained: The Psychology Behind Risk and Reward

Every day, people make financial decisions without necessarily noticing the patterns behind them. For example, many investors may sell stocks that are doing well too soon “to be on the safe side”, while holding on to losing stocks in the hope that they’ll rebound. This isn’t random behavior—psychologists Daniel Kahneman and Amos Tversky called that reflex loss aversion.

Their theory was: a Rs. 100 loss hurts more than a Rs. 100 gain pleases. That tilt, formalised in ‘Prospect Theory’, explains why we might hold on to purchase prices, misread probabilities, and swing between caution and rashness when markets move.

Table of contents

• What prospect theory says
• Key ideas
• How this can show up in investing
• Pricing, discounts, and framing tricks
• Simple tools to help neutralise loss aversion
• What this may mean for businesses and product owners

What prospect theory says

Traditional finance assumes investors make rational decisions, but behavioural finance shows that psychology and emotions often shape choices. One of its key ideas is prospect theory, which explains how people tend to respond to risk.

Prospect theory suggests that individuals evaluate outcomes relative to a reference point (often the purchase price) rather than in absolute terms. People also do not weigh probabilities objectively — they tend to overestimate small chances (like lottery wins) and underestimate larger probabilities (such as the potential for steady investment growth). This helps explain why investor behaviour often diverges from purely rational models.

Also Read: The Hidden Psychology Behind Your Money Habits

Key ideas

Reference points

Your feelings about gains or losses may depend on where you start. For example, if you buy a stock at ₹1,000 and it rises to ₹1,050, you may feel like you’re ahead — even if the stock remains overvalued. Drop to ₹950, and you may feel you’re in loss — even if fundamentals might have improved.

Loss aversion

Studies show that the pain of losses can feel about twice as intense as the joy of equivalent gains would. This explains why a 10% market drop may trigger panic, while a 10% rise may feel insufficient.

Diminishing sensitivity

The impact of wealth changes tends to decrease with scale. The difference between ₹0 and ₹10,000 may feel vast; between ₹10,00,000 and ₹10,10,000, the difference may fade in comparison — even though the gain is the same ₹10,000.

Probability weighting

People don’t always treat probabilities rationally. They may put too much weight on very small chances (such as betting on a lottery or a penny stock doubling overnight) while undervaluing more likely outcomes (such as the potential for steady compounding of a diversified investment over time).

In short, prospect theory shows that investors are influenced by various behavioural biases including reference points, fear of losses, diminishing sensitivity, and probability distortions. Recognising these may help investors avoid impulsive reactions and build more disciplined strategies.

How this can show up in investing

This confluence of various behavioural biases can impact investment decisions in various ways. Examples include:

The disposition effect

Investors often tend to sell stocks that are doing well to lock in realised gains, but may hold on to losing stocks hoping they recover. This may result in portfolios being tilted toward weaker performers.

Averaging down without clear reasoning

Anchored to the buy price, investors might increase holdings of weak stocks trying to erase losses. This may make the investment get bigger, while their confidence in it keeps falling.

Panic near lows

A series of losses may push investors toward high-risk “double down” moves or rash selling at precisely the wrong time.

Insurance and lotteries

Most people might happily pay for small-probability protection (extended warranties, flight insurance) because they tend to overweigh tiny risks. They may also buy lottery-like OTM (Out of the Money) options and meme bets because small probabilities of huge gains might seem more rewarding than they truly are. In many cases, the bet has a negative expected value, but psychologically it carries a positive perceived value.

Read Also: Investor Emotions & Market Cycles: A Behavioral Guide

Pricing, discounts, and framing tricks

Price increases vs cuts

A Rs. 50 price hike tends to feel worse than a Rs. 50 discount feels good. That’s why companies may often raise prices gradually and promote frequent small “offers”, since people tend to react more strongly to losses than to gains.

All-in vs add-on fees

An add-on fee tends to feel like a fresh loss; bundling might reduce that pain. That’s why “free delivery” with a higher base price has shown higher conversion rates.

Money-back guarantees

Once you “own” the product, giving it up may feel like a loss. Free trials, easy returns, and “Get the first month on us” lean on endowment effects based on the same tendency.

Simple tools to help neutralise loss aversion

Here are some approaches that may help reduce this tendency:

Write rules before you trade

Rules tend to beat feelings when it comes to investing. Define your trading and investment rules before entering the market. Set entry, exit, and position sizes and stick to them to avoid emotional reactions.

Reframe to long horizons

Zoom out. A 10-year compounding path is not decided by one quarter. Think long-term; short-term market moves shouldn’t derail well-planned strategies.

Separate decision from outcome

Judge yourself on process quality, not short-term profit or loss. A good decision might have a bad result and still remain good.

What this may mean for businesses and product owners

Businesses may consider using insights loss aversion to help customers, instead of focusing solely on optimising profits. Try presenting potential benefits as a series of small, visible wins, and group costs into a few predictable charges so while paying at checkout, it does not feel like a surprise loss. Try to set user-first defaults that most customers would reasonably choose, and keep the opt-out path obvious and quick.

Also Read: The Psychology of Smart and Intentional Spending

Takeaways

Many people tend to treat losses like emergencies and gains like ordinary events. But if you know where your reference point sits, why losses loom larger, and how probabilities get distorted, then you may be able to build systems that defend against your own instincts – and allow long-term discipline and compounding to play their role.

At Bajaj Finserv AMC, we recognise that emotions are the cornerstone of investor behaviour – not just for investors but for investment professionals too. That’s why, behavioural finance is at the heart of our investment philosophy, InQuBe, which combines the Information Edge, Quantitative Edge and Behavioural Edge. By understanding, tracking and monitoring market sentiments and our own investment biases, we seek to make mindful and strategic investment decisions. Get the Behavioural edge by investing with Bajaj Finserv AMC. Read more about InQuBe here.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.

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