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NISM-Series-X-B: Investment Adviser (Level 2) · Basics of Behavioural Finance

Prospect Theory and Loss Aversion Explained for NISM X-B

Updated 11 October 2026 · Fact-checked

Prospect theory, by Kahneman and Tversky, says people judge outcomes as gains or losses from a reference point, not as final wealth. Losses hurt more than equal gains please (loss aversion). The value function is S-shaped: concave for gains, convex for losses, and steeper for losses.

Understand Prospect Theory and Loss Aversion

Traditional finance assumes investors look at final wealth and maximise expected utility. Prospect theory, developed by Daniel Kahneman and Amos Tversky, describes how people actually decide when outcomes are uncertain. It is a descriptive theory. It explains real behaviour; it does not say what is optimal.

The key idea is the reference point. You do not judge an outcome by total wealth. You judge it as a gain or a loss against a benchmark, often the purchase price. A share bought at ₹100 now trading at ₹90 feels like a loss of ₹10, even if the investor's total wealth is high.

Loss aversion means a loss gives more pain than an equal gain gives pleasure. Research suggests the pain of a loss is roughly twice the pleasure of a same-sized gain, but treat that as an approximate finding, not a fixed number. This is why the value function is steeper on the loss side.

The value function is S-shaped. It is concave for gains, so you show risk aversion when you have gains: you prefer a sure gain over a gamble of equal expected value. It is convex for losses, so you show risk seeking when you face losses: you prefer to gamble to avoid a sure loss. It also shows diminishing sensitivity: the gap between ₹0 and ₹1,000 feels bigger than between ₹10,000 and ₹11,000.

Framing matters too. The same facts presented as a gain or as a loss lead to different choices. Prospect theory also says people overweight small probabilities and underweight moderate to high probabilities. In practice, this explains the disposition effect: selling winners too early and holding losers too long. An adviser can reduce this by setting goals, rules and a long-term view.

Key formulas to remember

Reference point
Outcome is judged as: Gain or Loss = Final outcome − Reference point
The reference point is often the purchase price or current wealth, not final total wealth.
Shape of value function
Gains: concave (risk averse) | Losses: convex (risk seeking) | Loss side is steeper
S-shaped curve passing through the reference point. The steeper loss side is loss aversion.
Loss aversion
Pain of a loss of ₹X > Pleasure of a gain of ₹X
Often described as about twice as strong, but this is an approximate research finding.
Disposition effect
Sell winners early + hold losers too long
Result of risk aversion in gains and risk seeking in losses.

How to solve Prospect Theory and Loss Aversion questions

Use this method for any question on prospect theory, loss aversion or framing.

  1. 1Identify the reference point in the question, such as the purchase price or current wealth.
  2. 2Classify each outcome as a gain or a loss relative to that point.
  3. 3If it is a gain, expect risk aversion and a preference for the sure option.
  4. 4If it is a loss, expect risk seeking and a preference for the gamble.
  5. 5Check whether the same facts are described differently; if so, the concept is framing.
  6. 6Look for losses felt more than gains of equal size; that is loss aversion.
  7. 7Match the behaviour to a named effect, such as disposition effect or holding losers.
  8. 8Eliminate options that say people judge only final wealth or are fully rational.

Quickest way: Gain or loss, then pick the behaviour

When to use it: Use when a question gives a short scenario and asks what the investor will do or which concept applies.

  1. Ask: gain or loss from the reference point?
  2. Gain means safe choice; loss means gamble.
  3. Same facts, different wording means framing.
  4. Loss hurts more than gain means loss aversion.
  5. Sells winners, holds losers means disposition effect.

Common mistakes in Prospect Theory and Loss Aversion

  • Saying people are risk averse in all situations under prospect theory.

    Traditional theory teaches risk aversion as the norm.

    Fix: Remember risk aversion applies to gains and risk seeking applies to losses.

  • Thinking the value function is a straight line or symmetric.

    Students forget the S-shape and the steeper loss side.

    Fix: Picture the S curve: concave above the reference point, convex below, steeper for losses.

  • Treating prospect theory as a prescriptive theory of what investors should do.

    Confusion with expected utility theory.

    Fix: Prospect theory is descriptive. It explains actual behaviour.

  • Measuring gains and losses against final wealth.

    Habit from traditional finance.

    Fix: Always use the reference point, often the purchase price.

  • Confusing framing with loss aversion.

    Both involve gains and losses.

    Fix: Framing is about wording changing the choice. Loss aversion is about losses weighing more than equal gains.

Worked examples

Example 1

An investor bought a share at ₹200. It now trades at ₹160. Offered a sure further loss of ₹20 or a 50% chance of losing ₹40 and 50% chance of losing nothing, she picks the gamble. Which concept best explains this?

Show the solution
  1. Reference point is the purchase price of ₹200, or current position.
  2. The choice is between losses, so the domain is losses.
  3. Both options have the same expected loss of ₹20.
  4. In the loss domain the value function is convex, so people are risk seeking.
  5. She prefers the gamble to avoid a sure loss.

Answer: Risk seeking in the domain of losses, as predicted by prospect theory.

Example 2

An investor holds Stock A with a gain of ₹5,000 and Stock B with a loss of ₹5,000. He sells A and keeps B, hoping it recovers. What is this behaviour, and what drives it?

Show the solution
  1. Identify the pattern: selling a winner and holding a loser.
  2. This is the disposition effect.
  3. Gains lead to risk aversion, so he locks in the sure gain.
  4. Losses lead to risk seeking and loss aversion, so he avoids realising the loss and gambles on recovery.

Answer: Disposition effect, driven by loss aversion and the different risk attitudes for gains and losses.

Exam tips

  • Expect scenario questions: decide whether the investor is in a gain or loss domain, then pick the behaviour.
  • Know the S-shape: concave for gains, convex for losses, steeper for losses.
  • Do not choose options that say investors are always rational or risk averse.
  • Be ready to name Kahneman and Tversky as the originators.
  • Negative marking is 25% of the question's marks. With four options, a blind guess has a slightly positive expected value: 0.25 × 1 − 0.75 × 0.25 = +0.0625 per mark. So guess when you can eliminate at least one option, and skip only if you have no idea.

Practice questions from Basics of Behavioural Finance

Prospect Theory and Loss Aversion in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Prospect Theory and Loss Aversion: frequently asked questions

What is prospect theory in simple words?

It says people judge outcomes as gains or losses from a reference point, not by final wealth. They dislike losses more than they like equal gains. Their risk attitude changes between gains and losses.

What is loss aversion in investing?

It is the tendency to feel a loss more strongly than a gain of the same size. It makes investors hold losing investments and avoid selling at a loss. It also makes them sell winners early.

How does the value function work?

It is S-shaped around the reference point. It is concave for gains, convex for losses, and steeper for losses. This explains risk aversion in gains and risk seeking in losses.

Is prospect theory a prescriptive theory?

No. It is descriptive. It explains how people actually decide, not how they should decide.