Behavior Finance - Prospect Theory

I know prospect theory relaxs the assumption of risk aversion and proposes loss aversion, but could someone please explain why it’s relevant to investors make decisions in two phases, i.e. early and edit phase. Thanks.

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.

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.

Thanks for the detailed explanation. It’s helpful:)

thanks for the expln. One qs. is the curve below the reference point for a loss averse investor is convex or concave? Seems to me concave in both down and up from the ref. Point.

A risk seeking investor has a convex utility function of wealth. An investor following the prospect theory is loss averse i.e. risk seeking below the ref point so it is convex.

Prospect theory is both concave and convex.

Convex from the bottom left quadrant to the middle of the chart.

Concave from the middle of the chart towards the uppar right quadarant.

if you are in a deep loss position, any gain from there ‘feels’ significantly better. Your utility from a unit of less loss is extremly high. As your position goes from a loss to a gain, you feel better but not as good as your initial transition from a deep loss to a less of a deep loss.

This is a case of increasing at an increasing rate (convex) transitioned to increasing at a decreasing rate (concave)


Convex below the reference point

And concave above the reference point like a “normal” rational risk averse investor