Prospect Theory: Meaning, Features and Example

People usually believe they make money decisions by thinking things through. But the moment there is risk, or even the chance of losing something, the mind starts reacting in ways that are not always logical. Prospect theory tries to make sense of this gap between what people say they will do and what they actually do. Once you look at it closely, a lot of investor behaviour suddenly feels easier to understand.

What Is Prospect Theory?

If someone asks what is prospect theory in the simplest terms, the idea is that people judge choices based on how they feel about gains and losses, not just on the final result. The emotional impact of losing something is stronger than the pleasure of gaining the same thing. That is the basic prospect theory meaning and the reason loss aversion prospect theory gets discussed so often.

Imagine dropping ₹500. You will probably think about it for the rest of the day. If someone hands you ₹500 unexpectedly, you feel good, but maybe not for long. That imbalance guides a surprising number of choices.

History of Prospect Theory

Prospect theory started with the work of Daniel Kahneman and Amos Tversky in 1979. They were trying to understand why people often reject perfectly logical bets. Their research cut through expected utility theory, which assumed individuals act rationally at all times. Kahneman later received the Nobel Prize for expanding this thinking, and their work helped shape what is now known as behavioural economics.

Their studies showed that emotions, memories and personal expectations influence decisions far more than traditional models admit. That became the base of Daniel Kahneman prospect theory discussions that continue today.

Components of Prospect Theory

There are a few components of prospect theory that explain why people react the way they do when facing risk. Think of them as the building blocks behind everyday financial choices.

• Reference point

People look at outcomes compared with where they currently stand or what they expected, not in absolute terms.

• Loss aversion

Losing feels worse than winning feels good. That single idea affects everything from investing to shopping.

• Diminishing sensitivity

The impact of gains and losses reduces as amounts get bigger. A small win feels exciting. A larger one feels good but not proportionally better.

• Probability weighting

People tend to misread probabilities. Rare events feel more likely than they are. Very likely events sometimes get treated casually.

These pieces make prospect theory vs expected utility theory a major debate in economics classrooms.

How Prospect Theory Works

Prospect theory explains decision-making using two stages. They sound technical, but in practice it is close to how people think naturally.

• Editing phase

Here, a person quickly sorts options. They decide which outcome counts as a gain and which as a loss, based on their own reference point.

• Evaluation phase

Then they look at the choices and react emotionally to potential losses and gains. The value curve for losses is steeper, which is a structured way of saying losses sting more.

This is why someone may reject a fifty-fifty gamble where they could lose ₹1,000 or gain ₹1,000. Even if the maths balances, the feeling does not.

On the other hand, the same person might accept a risky bet if the possible gain seems much larger than the potential loss.

Features of Prospect Theory

There are a few features of prospect theory that show why it feels so realistic compared with older economic ideas.

• Gains and losses are not equal

Losses take up more mental space.

• Framing matters a lot

If you present something as a gain, people behave one way. If the same thing is framed as a loss, they behave completely differently.

• Real-world usage

This theory explains why investors panic during market drops or hold losing stocks longer than makes sense.

• It acknowledges psychology

Most traditional models pretend people act like perfect calculators. Prospect theory accepts that they do not.

Example of Prospect Theory

A prospect theory example makes the idea much clearer. Picture an investor named Ramesh.

He has two choices.

Option A: A guaranteed gain of ₹10,000
Option B: A fifty percent chance to win ₹20,000 or win nothing

Most people take Option A. The certainty feels comforting, even though both choices have the same expected value.

Now change the framing.

Option C: A guaranteed loss of ₹10,000
Option D: A fifty percent chance to lose ₹20,000 or lose nothing

Here, many suddenly become willing to gamble. A guaranteed loss feels heavier than a potential one.

This flip in behaviour sits at the core of prospect theory.

Criticism of Prospect Theory

Even though the theory gets a lot of attention, there are a few prospect theory criticism points worth noting:

• It does not always work the same way

Different cultures and different personalities show different patterns.

• It is hard to measure

Turning emotions into numbers is complicated.

• It describes better than it predicts

It explains behaviour well but cannot always forecast it.

• It is complicated to model

The psychological parts make it tough for economists who prefer clean formulas.

Conclusion

Prospect theory makes financial decisions feel more human. It admits that losses carry extra weight, that framing matters and that investors do not always act with pure logic. When people learn to notice these patterns in themselves, choices about money start feeling calmer and more deliberate. Understanding these biases does not remove them completely, but it makes them much easier to manage.