Behavior Finance - Prospect Theory
- Thread starter FrankCFA
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myriam2222
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- Jun 18, 2026
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There are two phases in the prospect theory: the editing (also called framing phase) and the evaluation phase.
I can’t remember in which phase it happens (i have a hard time understanding what happens in which phase) but at some point, the investor will set a reference point and consider that the outcomes below that point represent a loss and the outcomes above represent a gain. This reference point can be the price he originally paid for the asset, or it can be way more arbitrary, for example if he inherited the asset, it may be the subjective value he has in mind for it (an anchor).
In any case this reference point is key for the investment decision although usually does not make much sense economically. For example if you use as a reference point the price that you paid for the asset, considering a total return analysis, you may sell it at a lower price and still have achieved very good total returns (dividends, interests, or operating income if it is capex).
This ref point is key because the loss averse investor’s utility function of wealth is convex below that point so where he sets the ref point will influence much his investment decision.
I can’t remember in which phase it happens (i have a hard time understanding what happens in which phase) but at some point, the investor will set a reference point and consider that the outcomes below that point represent a loss and the outcomes above represent a gain. This reference point can be the price he originally paid for the asset, or it can be way more arbitrary, for example if he inherited the asset, it may be the subjective value he has in mind for it (an anchor).
In any case this reference point is key for the investment decision although usually does not make much sense economically. For example if you use as a reference point the price that you paid for the asset, considering a total return analysis, you may sell it at a lower price and still have achieved very good total returns (dividends, interests, or operating income if it is capex).
This ref point is key because the loss averse investor’s utility function of wealth is convex below that point so where he sets the ref point will influence much his investment decision.
myriam2222
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- Jun 18, 2026
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My reasoning still does not fully end here and it may not address your question. I think some graphics would help. Or i don’t know how to explain better.
The idea is that when comparing various investment opportunities, the investor may not take the same investment decision if he is loss averse as if if he risk averse because if he is loss averse, he will ‘overreact’ to small losses. I was mentioning the ref point because this is were loss aversion starts.
When the investor is risk averse no ref point matters because the utility function of wealth has no inflection. So the investment decision won’t be impacted by such a subjective consideration.
The idea is that when comparing various investment opportunities, the investor may not take the same investment decision if he is loss averse as if if he risk averse because if he is loss averse, he will ‘overreact’ to small losses. I was mentioning the ref point because this is were loss aversion starts.
When the investor is risk averse no ref point matters because the utility function of wealth has no inflection. So the investment decision won’t be impacted by such a subjective consideration.
