Kahneman & Tversky — Prospect Theory: Why We Take More Risk When We Are Losing
Introduction
One of the most important ideas in behavioural finance begins with a simple question: Do people actually make financial decisions rationally? Traditional economic models often assume that individuals carefully evaluate probabilities, compare expected outcomes and choose the option that maximises their economic benefit. Kahneman and Tversky challenged this assumption through their groundbreaking work on Prospect Theory.
Their original paper, “Prospect Theory: An Analysis of Decision under Risk,” was published in Econometrica in 1979. The paper developed an alternative model of decision-making under risk and showed that people systematically make choices that cannot be fully explained by traditional expected-utility theory. (DOI)
For traders and investors, Prospect Theory is particularly important because it explains something we see repeatedly in financial markets: people often behave differently when they are making money than when they are losing money.A person who is cautious with profits can suddenly become much more willing to take risks when trying to recover a loss.
This is one of the reasons a trader who normally follows a disciplined strategy can suddenly start averaging down, removing a stop-loss, increasing position size or taking a highly risky trade after suffering a loss.
The Basic Idea Behind Prospect Theory
The central idea of Prospect Theory is that people do not evaluate financial outcomes simply by looking at their final wealth.
Instead, people tend to evaluate outcomes relative to a reference point.
This reference point can be the price at which you bought a stock, the amount of money you started with, your previous portfolio value, a target return or even an expectation you had about what should happen.
Imagine that you have ₹1,00,000.
If your portfolio increases to ₹1,10,000, you may think:
“I made ₹10,000.”
But if your portfolio falls to ₹90,000, you may think:
“I lost ₹10,000.”
The economic difference from the starting point is symmetrical: one is +₹10,000 and the other is −₹10,000.
Psychologically, however, they may not feel symmetrical.
That asymmetry is one of the foundations of Prospect Theory.
Gains and Losses Are Not Experienced Equally
Kahneman and Tversky proposed a value function that is generally concave for gains, convex for losses, and steeper for losses than for gains. (DOI)
This sounds complicated, but the intuition is relatively simple.
When people are in the gain domain, they tend to become more cautious as gains increase.
When people are in the loss domain, they can become more willing to take risks in an attempt to avoid accepting the loss.
Most importantly, the psychological impact of a loss is generally greater than the psychological impact of a comparable gain.
This is commonly described as loss aversion.
In simple terms:
Losing ₹10,000 can feel considerably worse than gaining ₹10,000 feels good.
That difference can strongly influence trading decisions.
What Is Loss Aversion?
Loss aversion is the tendency for people to give greater psychological weight to losses than to equivalent gains.
Suppose you have two possible outcomes.
In one situation, you gain ₹10,000.
In another, you lose ₹10,000.
From a purely mathematical perspective, these are equal in magnitude.
But psychologically, the loss may have a much stronger effect.
This creates a dangerous situation in trading.
A trader may become extremely protective of a small profit but become surprisingly aggressive when facing a loss.
The trader's behaviour changes depending on which side of the reference point they are on.
The Most Important Trading Lesson: Risk Aversion in Gains
Imagine you bought a stock at ₹100.
The stock rises to ₹120.
You now have a ₹20 gain.
You have two choices:
Option A: Take a guaranteed ₹20 profit.
Option B: Continue holding the stock with the possibility of making ₹40, but also the possibility that the price falls.
Many people prefer the certainty of the existing gain.
This reflects the tendency toward risk aversion in the gain domain, particularly when the gain is relatively certain. Kahneman and Tversky's original theory identified the certainty effect, in which certain outcomes receive disproportionate psychological weight compared with merely probable outcomes. (DOI)
This helps explain why traders may be tempted to book profits quickly.
The thought is:
“I already have ₹20. Why risk losing it?”
That reaction can be perfectly reasonable in some situations.
The problem occurs when it becomes a systematic behavioural pattern.
The Most Dangerous Part: Risk Seeking in Losses
Now consider the opposite situation.
You buy the same stock at ₹100.
Instead of rising, it falls to ₹80.
You now face a ₹20 loss.
Suppose you can choose between:
Option A: Accept a guaranteed ₹20 loss.
Option B: Take a risky bet that could allow you to recover the loss but could also produce an even larger loss.
Surprisingly, people may become more willing to take the gamble when they are trying to avoid a loss.
This is one of the most important insights from Prospect Theory.
Kahneman and Tversky's original paper describes the certainty effect as contributing to risk aversion for sure gains and risk seeking for sure losses. (DOI)
This provides a powerful explanation for behaviours such as:
“I don't want to book the loss.”
“I'll just wait for the stock to recover.”
“I'll average down.”
“I'll take one bigger trade to recover what I lost.”
The trader is no longer simply evaluating the probability and expected value of the next decision.
The trader is trying to escape the psychological pain of the loss.
Why a Losing Trader Can Become More Aggressive
This is one of the most important concepts for anyone learning to trade.
Imagine a trader starts the day with ₹1,00,000.
After several trades, the trader loses ₹10,000.
The trader now thinks:
“I need to recover ₹10,000.”
The psychological objective has changed.
The trader is no longer simply asking:
“Is my next trade a good opportunity?”
Instead, the trader is asking:
“How can I get my ₹10,000 back?”
That change can dramatically increase risk-taking.
The trader might increase position size.
They might trade without a strong setup.
They might remove their stop-loss.
They might enter options or leveraged positions.
They might continue trading even after their original strategy says to stop.
This is where Prospect Theory becomes extremely relevant to trading psychology.
The Trap of “Recovering the Loss”
Suppose you lose ₹10,000.
You now need a 11.11% return on the remaining ₹90,000 just to return to ₹1,00,000.
This is already a mathematical challenge.
But psychologically, the trader may think:
“I only need one good trade.”
That thought can become dangerous.
The trader may increase risk because the objective is no longer to make a good trade; it is to erase the emotional memory of the previous loss.
This can lead to what traders commonly call revenge trading.
Prospect Theory does not say that every instance of revenge trading is caused by the theory, but its framework helps explain why people can become more risk-seeking when they are facing losses.
The Reference Point Is Extremely Important
One of the most powerful concepts in Prospect Theory is the reference point.
Suppose you bought a stock for ₹500.
The stock is now worth ₹450.
You see the position as:
−₹50
But another investor who bought the same stock at ₹400 sees:
+₹50
Both investors own the same stock at the same market price.
The economic situation of the company is identical.
But psychologically, the two investors are in completely different domains.
One sees a loss.
The other sees a gain.
This means that the same ₹450 stock can produce completely different decisions depending on the investor's reference point.
Why Purchase Price Can Become Dangerous
This explains why traders often become emotionally attached to their entry price.
Imagine you buy a stock at ₹1,000.
It falls to ₹800.
You say:
“I'll sell when it gets back to ₹1,000.”
But why ₹1,000?
Because ₹1,000 is your reference point.
The market itself does not care that you bought at ₹1,000.
If the stock's future prospects have deteriorated, waiting for ₹1,000 may not be rational.
But because ₹1,000 represents “break-even” psychologically, you may continue holding the position.
This is one way Prospect Theory can help us understand the emotional difficulty of accepting losses.
Prospect Theory and the Disposition Effect
This connects directly with the Barber and Odean research discussed earlier.
The disposition effect describes the tendency to sell winners too quickly while holding losers too long.
Prospect Theory provides one psychological explanation for why this may happen.
When a position is profitable, the investor is in the gain domain and may become more risk-averse.
Therefore:
“I have a profit. I should secure it.”
When a position is losing, the investor enters the loss domain and may become more willing to take risks.
Therefore:
“I don't want to accept the loss. I'll wait for recovery.”
This creates:
Winner → risk aversion → sell
Loser → risk seeking → hold or gamble
This is an important connection between behavioural decision theory and actual investor behaviour.
A Simple Trading Example
Imagine two traders.
Trader A: The Winning Position
Trader A buys a stock at ₹100.
It rises to ₹120.
The trader has a choice between taking the ₹20 profit or continuing to hold.
The trader becomes nervous about losing the profit and sells.
Trader B: The Losing Position
Trader B buys another stock at ₹100.
It falls to ₹80.
The trader refuses to sell.
Instead, the trader buys more at ₹80.
The price falls to ₹60.
The trader buys even more.
Eventually, a manageable loss becomes a very large position with a much greater downside.
This behaviour is not necessarily caused by Prospect Theory alone, but Prospect Theory provides a powerful framework for understanding why the psychological experience of a loss can change risk preferences.
The Certainty Effect
Another important concept in the original paper is the certainty effect.
People tend to give special weight to outcomes that are certain compared with outcomes that are merely probable. Kahneman and Tversky used this effect to explain why people may be risk-averse when choosing among gains but risk-seeking when dealing with certain losses. (DOI)
Imagine these two choices.
Situation A — Gains
You can receive:
₹10,000 for certain
or
80% chance of ₹15,000.
Many people prefer the guaranteed ₹10,000 even though the expected monetary value of the second option is ₹12,000.
The certainty of the ₹10,000 carries psychological weight.
Situation B — Losses
Now imagine:
Lose ₹10,000 for certain
or
80% chance of losing ₹15,000.
People may prefer the gamble because there is a chance of avoiding the certain loss.
This reversal is extremely important.
The person is not necessarily becoming irrational in a random way.
Their risk preference changes depending on whether they are experiencing a gain or a loss.
The Fourfold Pattern of Risk Behaviour
The later development of the theory, Cumulative Prospect Theory, provided an even richer framework.
In their 1992 paper “Advances in Prospect Theory: Cumulative Representation of Uncertainty,” Tversky and Kahneman extended Prospect Theory to more complex uncertain situations and identified a fourfold pattern of risk attitudes. (DOI)
The pattern can be simplified as follows:
Situation | Typical Behaviour |
High-probability gain | Risk-averse |
Low-probability gain | Risk-seeking |
High-probability loss | Risk-seeking |
Low-probability loss | Risk-averse |
This is fascinating because it means human risk-taking is not simply:
“People hate risk.”
or
“People love risk.”
Instead, risk preference can depend on whether the outcome is a gain or loss and how likely the outcome is.
Why People Buy Lotteries and Insurance
The theory can even help explain behaviours that initially seem contradictory.
Why would someone buy a lottery ticket when the probability of winning is extremely small?
And why would the same person buy insurance to protect against a rare disaster?
Cumulative Prospect Theory explains that people may overweight small probabilities. The 1992 paper notes that this can contribute to the attractiveness of both gambling and insurance. (DOI)
In simple terms:
A tiny probability of a huge gain can feel more significant than its mathematical probability suggests.
Likewise, a tiny probability of a catastrophic loss can feel sufficiently important to justify paying for protection.
This is one reason human decision-making cannot always be explained by simply multiplying probability by monetary outcome.
How This Appears in Financial Markets
Prospect Theory has many applications in investing and trading.
Consider a trader holding a losing option position.
The option is rapidly losing value.
The rational response might be to reassess the position based on its current probability of success.
But psychologically, the trader may think:
“I've already lost so much. I might as well hold it.”
The trader may even add more money because the possibility of a large recovery has become psychologically attractive.
This is exactly the kind of situation in which risk-seeking behaviour in the loss domain can become dangerous.
The “Double Down” Mentality
Suppose a trader loses ₹5,000.
They then take another trade risking ₹10,000.
If that trade loses, they risk ₹20,000.
The trader's logic may be:
“I need a bigger win to recover everything.”
This is not disciplined risk management.
The trader is allowing the previous loss to influence the risk level of the next independent decision.
Prospect Theory helps us understand why this can happen: once the trader psychologically enters the loss domain, the desire to escape the loss can increase willingness to take risk.
Why Averaging Down Can Become Psychological
Averaging down is not automatically wrong.
There are legitimate investment situations in which adding to a position after a decline can be rational.
The problem occurs when the only reason for adding is:
“The price has fallen, so I don't want to admit that I was wrong.”
The trader may believe that buying more will reduce the average purchase price and make it easier to get back to break-even.
But lowering the average entry price does not automatically reduce the economic risk of the investment.
If the underlying asset continues to decline, the trader simply has more money exposed to the same losing thesis.
Prospect Theory Does Not Say That Risk-Seeking Is Always Irrational
This distinction is important.
Kahneman and Tversky's theory is a descriptive model of human decision-making under risk. It explains patterns in how people actually make choices; it does not say that every risk-seeking decision is necessarily irrational or that every risk-averse decision is correct.
For example, taking a calculated risk to recover from a loss can sometimes be economically justified.
The important point is that the emotional framing of the outcome can influence the decision.
A trader should therefore ask:
“Would I take this trade if I had not experienced the previous loss?”
If the answer is no, the previous loss may be influencing the decision.
The Importance of Framing
Prospect Theory also demonstrates that the way a decision is presented can influence the choice.
Kahneman and Tversky called this related phenomenon the framing effect. The original paper discusses the isolation effect and shows that preferences can change when the same choice is presented differently. (DOI)
In trading, consider these two statements:
“You have made ₹20,000.”
and
“You are ₹20,000 away from recovering your previous loss.”
The underlying financial amount might be similar, but psychologically they can create completely different reactions.
The first statement may encourage caution.
The second may encourage risk-taking.
This is why traders need to be careful about the language they use internally when evaluating positions.
Why “Break-Even” Is a Psychological Trap
Break-even is a mathematical concept, but it can become a psychological obsession.
Imagine you bought a stock for ₹1,000.
It falls to ₹700.
You think:
“I just need ₹300 more to get back to break-even.”
But from the current perspective, the stock does not know that you bought it at ₹1,000.
The relevant question is:
“What is the best decision I can make with ₹700 today?”
If you would not buy the stock today at ₹700, continuing to hold it simply because you want to return to ₹1,000 may be an emotional decision.
This is one of the most useful applications of Prospect Theory for new traders.
How Prospect Theory Explains Revenge Trading
Revenge trading is the behaviour of taking new trades primarily to recover previous losses.
For example:
You lose ₹5,000.
You become frustrated.
You immediately enter another trade.
You lose another ₹5,000.
You become even more determined.
You increase your position size.
Eventually, the goal is no longer:
“Find a good trading opportunity.”
The goal becomes:
“Get my money back.”
This is a fundamental psychological shift.
The trader has moved from decision-making based on opportunity to decision-making based on loss avoidance.
Prospect Theory helps explain why this transition can increase risk-taking.
How to Use Prospect Theory as a Trader
Understanding Prospect Theory is useful only if it changes behaviour.
The first practical step is to separate the current decision from the previous outcome.
Suppose you lost ₹10,000 yesterday.
Today you see a trading opportunity.
Do not ask:
“Can this trade recover yesterday's ₹10,000?”
Ask:
“If I had started today with my current account balance and knew only today's information, would I take this trade?”
That question helps remove the previous loss from the decision.
Set Risk Before Entering the Trade
One of the simplest ways to protect yourself from loss-driven risk-taking is to determine the maximum risk before entering the trade.
For example:
Maximum loss per trade = predetermined percentage of capital.
Once that number is established, you should not increase the risk simply because the previous trade was a loss.
This creates a critical rule:
A previous loss should not automatically increase the risk of the next trade.
The next trade should be evaluated independently.
Stop-Losses and Prospect Theory
A stop-loss can be psychologically difficult because it forces the trader to accept a loss.
That is exactly why some traders repeatedly move their stop-loss farther away.
The original plan might have been:
Exit at ₹95.
The stock falls to ₹95.
The trader says:
“I'll give it a little more room.”
Then ₹90.
“It is oversold. It should recover.”
Then ₹80.
Now the original risk plan has disappeared.
The trader is no longer following the strategy.
They are trying to avoid experiencing the loss.
Understanding Prospect Theory can help a trader recognise what is happening psychologically.
The Difference Between Accepting a Loss and Giving Up
Accepting a loss does not mean giving up.
It means recognising that uncertainty is part of trading.
A professional approach is not:
“I must avoid every loss.”
It is:
“I must ensure that one loss does not damage my ability to continue trading.”
A trader who accepts small losses according to a predefined strategy can remain in the game.
A trader who refuses to accept small losses may eventually create a very large loss.
Prospect Theory and Options Trading
The concepts become particularly important in options because options can create highly asymmetric outcomes.
A trader may lose money repeatedly on small option positions while continuing to buy options because of the possibility of a large payoff.
This can relate to the tendency to overweight small probabilities of large gains.
On the other side, a trader facing a large loss may take even greater risks in an attempt to recover it.
Therefore, options can become psychologically dangerous when the trader focuses primarily on the possibility of a large payoff rather than the probability and expected distribution of outcomes.
Prospect Theory helps explain why some highly uncertain opportunities can appear more attractive psychologically than they appear mathematically.
Prospect Theory and Gambling
This also connects to the earlier question of trading versus gambling.
Prospect Theory does not say that trading is gambling.
Instead, it helps explain why humans can be attracted to uncertain outcomes.
The theory notes that people may overweight low probabilities, which can contribute to the appeal of both gambling and insurance. (DOI)
In trading, the problem arises when someone starts seeking the emotional excitement of uncertain outcomes rather than making decisions based on a tested process, risk management and information.
A trader who repeatedly takes high-risk positions because of the possibility of a huge payoff may be responding to psychological biases rather than following a disciplined strategy.
What a New Trader Should Remember
The biggest lesson from Prospect Theory is not that traders should avoid all risk.
Trading necessarily involves risk.
The lesson is that your attitude toward risk can change depending on whether you are winning or losing.
When you are profitable, you may become too cautious and exit too early.
When you are losing, you may become too aggressive and take risks that you would never have taken before the loss.
That change in behaviour can be extremely dangerous.
The trader should therefore try to create rules that remain stable regardless of the emotional state created by the previous trade.
A Practical Mental Checklist
Before taking a trade after a loss, ask yourself:
Would I take this trade if my previous trade had been profitable?
Am I taking this trade because it is a good opportunity or because I want my money back?
Has my position size increased because I am trying to recover?
Would I still enter this trade if I had no previous position?
Am I accepting the risk because it makes sense, or because accepting the loss feels worse?
These questions can help identify when Prospect Theory may be influencing your behaviour.
The Most Powerful Lesson
Perhaps the most important lesson from Kahneman and Tversky is that people do not always evaluate outcomes in absolute financial terms.
We evaluate them relative to a reference point.
A ₹10,000 gain can feel very different from a ₹10,000 loss.
A ₹100 stock can look attractive to one investor and terrible to another depending on what each investor paid.
A risky trade can look unacceptable when we are profitable but suddenly become attractive when we are trying to recover a loss.
This is why trading psychology cannot be separated from trading performance.
Final Takeaway for a New Trader
Kahneman and Tversky's Prospect Theory fundamentally changed how economists and psychologists understand decision-making under risk. Their 1979 paper challenged the idea that people consistently behave according to traditional expected-utility theory and showed that choices are influenced by certainty, framing, reference points and the different psychological treatment of gains and losses. (DOI)
For traders, the most important insight is loss aversion and the different shape of the value function for gains and losses. People tend to become more risk-averse when dealing with gains but can become risk-seeking when trying to avoid a loss. (DOI)
This can explain why a trader may happily take a small profit but refuse to accept a small loss. It can explain why someone might hold a losing position, average down, move a stop-loss, or take an increasingly risky trade simply because they want to return to break-even.
The later Cumulative Prospect Theory developed by Tversky and Kahneman in 1992 extended the framework to broader uncertain situations and identified a fourfold pattern of risk attitudes depending on gains, losses and probability levels. (DOI)
The practical lesson is simple:
Do not allow your previous loss to determine the risk of your next trade.
A ₹10,000 loss does not create a requirement to make ₹10,000 on the next trade.
The next trade should be judged independently on its own probability, risk, reward and evidence.
A disciplined trader is not someone who never loses.
A disciplined trader is someone who can experience a loss without allowing that loss to change the rules of the next decision.
In One Sentence
Prospect Theory explains why traders may become cautious when they are winning but surprisingly willing to take greater risks when they are losing—helping us understand behaviours such as holding losers, averaging down and revenge trading.
Research Papers & Resources
Kahneman, D., & Tversky, A. (1979). “Prospect Theory: An Analysis of Decision under Risk.” Econometrica, 47(2), 263–291. This is the foundational Prospect Theory paper. (JSTOR)
Tversky, A., & Kahneman, D. (1992). “Advances in Prospect Theory: Cumulative Representation of Uncertainty.” Journal of Risk and Uncertainty, 5, 297–323. This paper develops Cumulative Prospect Theory and expands the original framework to more complex uncertain prospects. (DOI)
The DOI provided in your reference: Prospect Theory: An Analysis of Decision under Risk, DOI 10.1142/9789814417358_0006, is the later handbook version of the paper. (DOI)
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