Behavioral Finance: Prospect Theory
In the previous article about Randomness, Efficiency, we learned that markets frequently experience extreme events, known as fat tails, in contrast to the normal distribution assumed by the Efficient Market Hypothesis.
Mediocristan, they fluctuate mildly and behave in a normal, predictable manner. People remain calm and rational, and traders’ account balances experience little change. Different motivations lead to diverse buying and selling decisions, making price movements appear truly random. But when prices begin to rise, those who bought earlier become more confident in their decisions—they buy more aggressively, believing they are smart and spreading this belief to others. Positive news begins to flood in, and more investors start thinking that prices will continue to rise. Slowly, they lose their rationality. At such moments, their motivations become aligned—they all become greedy, fearful, biased, and emotional in the same way, creating a positive feedback loop that drives prices sharply higher into the realm of Extremistan. This is when the fat tails emerge. And once the price has gone too far, it eventually collapses in a loop that mirrors the path it took on the way up.
We can observe this phenomenon quite frequently in the crypto market, where countless projects are built in a typical “pump and dump” fashion. Developers and market makers create hype, news, and trading algorithms to push prices into an upward trend—what can be called a bait trend—after having accumulated a large number of tokens beforehand. Once the price reaches a certain threshold, emotionally-driven investors begin to spread the word and rush in to buy, driving prices to extreme levels and triggering massive pumps.
Right at that moment, those market makers begin to sell. They cleverly exploit the greed, fear, and irrationality of others to make money. They repeat this exact behavior over and over—month after month, year after year.
Money on the market keeps flowing from the pockets of emotional traders into the hands of those who are rational and intelligent. Although this kind of manipulation can typically only occur in low-cap markets where supply is largely controlled by a few individuals, it clearly demonstrates how flawed the assumptions of the efficient market hypothesis truly are.
The graph above is a value function that accurately reflects human nature. Our emotions are much more strongly affected by losses than by gains—the pain we feel from losing $50 is far greater than the joy of gaining the same amount.
The right side of the curve, representing the domain of gains, shows how our sensitivity to profit diminishes as the profit increases. We perceive the difference between earning 20 more strongly than between earning 1,020.
In contrast, on the left side of the curve—the loss domain—our sensitivity decreases as the losses grow larger. If we observe the chart carefully, it reveals a deeper insight: humans are generally risk-averse when seeking gains, but they become far more willing to take risks in order to avoid losses.
Humans have a much stronger fear of losing money they already possess compared to losing money they haven’t yet acquired. This is because the pain of loss is far greater than the pleasure of gain. Results from Prospect Theory experiments show that most people are unable to hold onto winning trades—they tend to close them too early to secure a small profit. On the other hand, they do the opposite with losing trades: unwilling to admit they were wrong, they refuse to take a small loss and instead hold on, hoping the trade will return to breakeven. As a result, the loss often grows excessively.
These individuals act primarily on emotion rather than expected value. They view reality through a distorted lens shaped by personal feelings. Those who let emotions drive their actions clearly fail to take advantage of the positive outcomes associated with fat tails in the market. They lose money consistently and ultimately become a steady source of profit for more rational and intelligent participants.
Therefore, if we want to be among the winners, we must act against our natural instincts—learn to admit when we’re wrong and avoid holding onto losing positions for too long. We need to build trading strategies where losses are strictly controlled with tight stop-loss orders, while profits are left open and allowed to run as far as possible.
We must wait for a trend to form and enter early in its development. These small trends can evolve into much larger ones. When prices begin to move sharply and enter the Extremistan zone, our results will be heavily influenced by extreme values. Since we’ve already cut off the negative outcomes, we’ll be positioned to capture the positive ones. That is the foundation for making a profit.