đź“ŚProspect theory; what is it?

đź“ŚProspect theory; what is it?

Humans are not psychologically good traders by nature !

Have you ever wondered, why trading with real money is overwhelming for you?!
The reason should be sought in the psychological aspect of the case. If you lose amount of money in the market, you must gain a several times profit , to satisfy yourself ,so in thus case the feeling of happiness overcomes the pain of your initial loss!
although all traders, even successful traders, have tasted loss and it is an inevitable part of the trading journey !But the successful traders have learned how to control the psychologically of it and not be limited by the feelings of a loss!

Prospect theory : also called loss-aversion theory is a theory of behavioral economics and behavioral finance that was developed by Daniel Kahneman and Amos Tversky in 1979. .Daniel Kahneman the author of ‘ Thinking, Fast and Slow ‘ book is a Nobel Laureate in Economics who is a psychologist by training. He won the prize mostly for his work in decision making, specifically Prospect Theory. This book distills a lifetime of work on the engine of human thinking, highlighting our cognitive biases and showing both the brilliance and limitations of the human mind. This summary attempts to capture some of the more interesting findings.

Based on results from controlled studies ,he describes how individuals assess their loss and gain perspectives in an asymmetric manner (see loss aversion). For example, for some individuals, the pain from losing $1,000 could only be compensated by the pleasure of earning $2,000 or even more. Thus, contrary to the expected utility theory (which models the decision that perfectly rational agents would make), prospect theory aims to describe the actual behavior of people.

In the original formulation of the theory, the term prospect referred to the predictable results of a lottery. However, prospect theory can also be applied to the prediction of other forms of behaviors and decisions.

Prospect theory: stems from Loss aversion, where the observation is that agents asymmetrically feel losses greater than that of an equivalent gain. It centralises around the idea that people conclude their utility from “gains” and “losses” relative to a certain reference point. This “reference point” is different for each person and relative to their individual situation. Thus, rather than making decisions like a rational agent (i.e using expected utility theory and choosing the maximum value), decisions are made in relativity not in absolutes.

Consider two scenarios;

100% chance to gain $450 or 50% chance to gain $1000
100% chance to lose $500 or 50% chance to lose $1100
Prospect theory suggests that;

When faced with a risky choice leading to gains agents are risk averse, preferring the certain outcome with a lower expected utility (concave value function).
Agents will choose the certain $450 even though the expected utility of the risky gain is higher
When faced with a risky choice leading to losses agents are risk seeking, preferring the outcome that has a lower expected utility but the potential to avoid losses (convex value function).
Agents will choose the 50% chance to lose $1100 even though the expected utility is lower, due to the chance that they lose nothing at all
These two examples are thus in contradiction with the expected utility theory, which only considers choices with the maximum utility. Also, the concavity for gains and convexity for losses implies diminishing marginal utility with increasing gains/losses. In other words, someone who has more money has a lower desire for a fixed amount of gain (and lower aversion to a fixed amount of loss) than someone who has less money.

source: wikipedia

Well, with these concepts , we conclude that Losses loom larger than gains! the Psychological value of a loss equal or even less than previous profit, can really affect our mindset , and feeling for trade, actually trading bots are better than us in this aspect, or better to say ;humans should have a proper trading system , also should cultivate our discipline and diligence to be a good trader(psychologically ) !

this article is For informational purposes only!

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