Prospect theory states that investor perceptions of gain and loss are skewed. The underlying principle of the theory is that people are more afraid of loss than they are motivated by gain. If people are given a choice of two different prospects, they will pick the one that they think has less chance of ending in a loss, rather than the one that offers the most gains. When given investment choices, people will often pick less profitable investments because they put an irrational amount of importance on losses while ignoring gains that are of greater value.
Prospect theory is important not because it helps us understand what to do, but because it warns us of a potential error that we can make if we don’t do things rationally “by the numbers.” Prospect theory teaches us that very few people understand emotionally what they realize intellectually when it comes to assessing risk and reward. It also tells us that if an investment doesn’t pass the sleep test, it should not be purchased, regardless of the expected return. It also suggests that we formulate our investment strategy when we are cool, calm, and collected, and stick to our plan when the markets start acting crazy and emotionality creeps in.
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