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

In prospect theory, which feature of the value function best explains why investors often sell winning investments too early while holding losing ones?

Prospect theory's value function is concave for gains and convex for losses around a reference point. This makes investors risk averse when ahead and risk seeking when behind, leading them to sell winners early and keep losers, the pattern known as the disposition effect.

  1. AIt is concave for gains and convex for losses relative to a reference pointCorrect
  2. BIt is linear in both gains and losses around the reference point
  3. CIt is convex for gains and concave for losses relative to a reference point
  4. DIt depends only on final wealth and not on changes

Explanation

Prospect theory evaluates gains and losses from a reference point. Concavity in gains makes investors risk averse when ahead, so they lock in profits. Convexity in losses makes them risk seeking when behind, so they hold losers hoping to recover. Options linear, reversed or based on final wealth contradict the theory.

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