Expected Utility vs Prospect Theory

The prospect theory, developed by Kahneman and Tversky, provides a novel perspective on how individuals perceive losses and gains. According to this theory, people tend to feel more unhappy about a monetary loss than they feel happy about an equivalent gain. This phenomenon suggests that the emotional pain associated with loss weighs more heavily on our experience than the pleasure derived from gains. In the presented graphs, the traditional utility model displays a flat line, representing a linear approach to gains, while the prospect theory visualizes a curved line, highlighting the asymmetry in financial emotions. This paradigm shift has significant implications for economic decisions, suggesting that people might make more conservative choices to avoid losses rather than maximize gains.

Prospect theory offers an interesting view on individuals' behavior when facing risk. In particular, it differs from the traditional expectations of rational economists, as it highlights how risk aversion is stronger towards losses than towards gains. This phenomenon is represented in the bottom left quadrant, where people seek to avoid losses rather than maximize gains. Furthermore, it is crucial to consider the reference point, which serves as a baseline for economic decisions, located at the intersection of the vertical and horizontal lines in the graph. Understanding these factors helps us better predict individuals' choices and their reactions in varying economic contexts, suggesting that emotions and perceptions play a crucial role in our interpretation of risk.

When we venture beyond established boundaries, we can find ourselves in dangerous territory where decisions can lead to unintended consequences. Take our situation with Apple stocks as an example: you and I may have differing opinions on the optimal time to buy or sell. While you might be inclined to sell amid a downturn, I may choose to hold onto the stocks, hoping for a future recovery. This diversity of viewpoints is what makes the stock market so fascinating and unpredictable. Each of us, with our own strategy, seeks to achieve the same goal: maximizing our profit, but the ways we get there can vary unexpectedly. Our choices, therefore, are fundamental in determining our success.

I purchased my shares at $25.

When investing in stocks like Apple, the feeling of gain can be very rewarding. Currently trading at $35, those who bought at $25 are certainly enjoying a positive period, having gained $10 per share. The decision to sell, despite believing in the company's future potential, can be influenced by one's risk aversion; realizing a guaranteed gain can lead to greater peace of mind. On the other hand, those who invested at a higher price, such as $45, find themselves in a difficult situation as selling would result in a loss. This dichotomy between the desire to maintain the investment and the fear of losing money is one of the primary challenges for many investors, who often find themselves weighing risk and return.

You will recognize not only on paper but in real dollars that you have lost $10 per share.

You are searching for opportunities, driven by the hope that Apple may reverse its current negative trend. Despite your concerns about the stock's decline, you are working to find compelling reasons that could lead to a rebound. That crucial $45 point represents the price at which you invested, a level you are eager to surpass. However, it is important to remember that for Apple and the financial market, that number is just an abstract incidence, devoid of meaning. For you, however, that milestone takes on personal significance, becoming a symbol of your resilience and your investment strategy. You are determined to challenge the risk and discover whether the future will lead your stock to redeem its lost value, taking it beyond that limit you so desire.

In the world of investing, it is crucial to adopt a rational approach when deciding to sell your shares. One should not base the decision on arbitrary factors, such as the purchase price, but rather focus on the future prospects of the company in which you are investing. In the case of Apple, for example, it is crucial to assess whether you anticipate a positive or negative trend, rather than being guided by emotions or personal beliefs. This perspective not only helps to make more informed decisions but also reflects the principles of prospect theory, which offers a broader understanding of attitudes towards risk compared to expected utility theory. Therefore, a strategic sale of shares should always consider market prospects and not just immediate profit or loss relative to the purchase price.