Prospect theory in practice
In this chapter: Asymmetric loss-gain perception · Implications for risk profiling
Prospect theory (Kahneman & Tversky 1979) describes actual decision-making under risk: people are risk-averse for gains and risk-seeking for losses, with reference points anchoring perception. A ₹1 crore portfolio at ₹1 crore is "neutral"; at ₹95L is a "loss"; at ₹105L is a "gain" — even though all three are absolute wealth.
Implications for risk profiling: a static questionnaire assumes risk tolerance is stable; prospect theory shows it shifts with reference points. After gains, investors are risk-averse (don't want to give back). After losses, they're risk-seeking (try to make it back). Practitioner approach: re-assess risk tolerance during major market moves; document with client signature. Mental accounting: investors treat money differently based on its "label" — house-deposit money vs holiday-fund vs retirement vs windfall. Each gets a different risk profile in their mind. Goal-based investing leverages this — different goals get different portfolios, matching the mental compartments.
Practitioner insight: framing changes decisions. "You'll lose ₹3L if this drops 10%" hits differently from "your portfolio could be at ₹97L if this drops 10%". Same outcome, different frame. Sophisticated advisors use frame manipulation ethically — emphasising long-term gains (smaller-feeling) vs short-term losses (larger-feeling) shifts client decisions. Also: status-quo bias is a meta-bias — people prefer existing positions over rationally-better alternatives. The advisor must overcome this when rebalancing portfolios that have drifted.