Kahneman & Tversky (1979): Prospect Theory and the Irrational Investor

#The Three Pillars of Prospect Theory

Prospect theory dismantled rational economic models through three fundamental psychological observations.

1. Evaluation Relative to a Reference Point In classical theory, individuals only care about total wealth. In reality, people evaluate wealth relative to a *reference point*. The absolute value matters far less than the trajectory relative to the anchor.

2. Loss Aversion Through repeated trials, Kahneman and Tversky discovered the human brain processes loss and gain asymmetrically. **The pain of losing $100 is roughly 2 to 2.5 times more intense than the joy of finding $100.** Investors isolated to avoid crystallizing a loss on paper.

3. Asymmetric Risk Tolerance - When faced with a **gain**, humans become highly *risk-averse*. - When faced with a **loss**, humans become hopelessly *risk-seeking*. People will widely gamble out of desperation to avoid the definitive loss.

#The Impact on the Stock Market

How does Prospect Theory translate into 10-figure algorithmic factor premiums? It drives the Disposition Effect, which in turn drives the Momentum and Value anomalies.

Why Momentum Works: When a company reports blowout earnings, retail investors who owned the stock are faced with a Gain. They become risk-averse and sell the stock purely to lock in the win. This irrational selling forces the stock price to underreact to the good news. Over the next 6-12 months, the stock slowly grinds relentlessly higher as reality sets in. This is Momentum.

Why Value Works: Conversely, when a company reports a tragedy, investors are faced with a Loss. They become highly risk-seeking. Instead of accepting the loss, they hold onto the distressed, dying company. The stock languishes in structural mispricing for years.