Prospect theory explains these irrational decisions from "summary" of Advances in Behavioral Finance by Richard H. Thaler
Prospect theory, developed by Kahneman and Tversky, offers a framework to understand why individuals make irrational decisions when faced with uncertainty. Traditional economic theory assumes that individuals are rational and always make decisions that maximize their utility. However, Prospect theory challenges this assumption by suggesting that individuals evaluate potential outcomes relative to a reference point, such as their current wealth or status quo. According to Prospect theory, individuals are risk-averse when faced with gains and risk-seeking when faced with losses. This asymmetry in decision-making can lead to irrational behavior, such as holding onto losing investments in the hope of breaking even or selling winning investments too soon to secure a profit. These actions deviate from the rational decision-making process predicted by traditional economic models. Furthermore, Prospect theory introduces the concept of loss aversion, which suggests that the pain of losing is psychologically more significant than the pleasure of gaining. As a result, individuals are more likely to take risks to avoid losses rather than to achieve gains. This tendency can lead to suboptimal decision-making, as individuals may prioritize avoiding losses over maximizing gains.- Prospect theory provides valuable insights into understanding why individuals make irrational decisions in the face of uncertainty. By incorporating psychological factors such as loss aversion and reference points into economic decision-making models, Prospect theory offers a more realistic depiction of human behavior. This framework helps explain the deviations from rationality observed in financial markets and other decision-making contexts.
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