Prospect theory: how we really weigh risk

Kahneman and Tversky's most famous contribution is prospect theory, a model of how people actually make decisions involving risk and reward. It replaces the textbook idea that we maximize expected value with something far closer to real behavior.

Three findings that matter to traders

1. Losses hurt more than equivalent gains feel good. The pain of losing 100 is roughly twice the pleasure of gaining 100. This asymmetry — called loss aversion — is the engine behind half the mistakes in trading.

2. We judge outcomes relative to a reference point, not in absolute terms. Whether you feel like a winner depends entirely on where you started. A position up 5% feels like a loss if it was once up 20%.

3. We are risk-averse with gains but risk-seeking with losses. Faced with a sure gain, people lock it in early. Faced with a sure loss, people gamble to avoid it.

The classic experiment

Offered a guaranteed 900 versus a 90% chance of 1,000, most people take the sure 900 — playing it safe with a gain. But offered a guaranteed loss of 900 versus a 90% chance of losing 1,000, most people take the gamble — risking a bigger loss to avoid certain pain. The math is nearly identical; the behavior flips completely.

How it plays out in a trading account

This is the exact mechanism behind one of the most destructive habits in trading: cutting winners short and letting losers run. A trade goes green and you snatch the small profit, terrified of giving it back. A trade goes red and you refuse to sell, gambling that it comes back rather than locking in the loss.

Up 300 → "Take it now before it's gone."   (risk-averse with a gain)
Down 300 → "I'll wait, it'll recover."     (risk-seeking with a loss)

That single pattern, repeated, guarantees that your average win is smaller than your average loss — the opposite of what a profitable strategy requires. Recognizing prospect theory at work is what lets you override it.