The Science Behind Losing Money in Stocks: How the Nobel Prize-Winning "Prospect Theory" Makes You Buy High and Sell Low

Have you ever wondered — you’ve poured tons of time and energy into the stock market, only to bail out early and then feel reluctant when stocks start making money? I recently read a book that introduced something called “Prospect Theory,” and I found it incredibly fascinating. With just two questions, we can easily find the answer, understand your true feelings about stock investing, and learn how to manage your money more wisely.

What Is Prospect Theory?

Prospect Theory was developed by two behavioral economists, Daniel Kahneman and Amos Tversky. The theory primarily explains how people make decisions when facing uncertain choices. According to their research, people feel the pain of losing something far more intensely than the joy of gaining something equivalent. This explains why many investors play it safe even when there’s potential for bigger gains.

How Does Prospect Theory Affect Your Investment Decisions?

Question 1

You win NT$1 million in the lottery. Now you have the chance to flip a coin once. What would you do? Take the NT$1 million and walk away, or flip the coin — heads, you win NT$2 million; tails, you lose all your winnings.

Question 2

You have NT$2 million in debt. Now you get another chance to gamble. What would you do? Accept an unconditional NT$1 million debt reduction (leaving you with NT$1 million in debt), or flip the coin — heads, your debt is wiped clean; tails, your debt stays the same.

Your Psychological State Overrides Rational Facts — That’s the Essence of Prospect Theory

The answers to both questions are mathematically identical, but most people choose the conservative option when facing gains and the risky option when facing losses. This is what makes Prospect Theory so fascinating — it explains how our financial decisions are driven by emotion rather than logic.

Common Psychological Traps in Investing

1. Loss Aversion: Because the pain of losing feels stronger than the pleasure of gaining, investors panic at even minor dips in stock prices and abandon their investment plans.
2. Confirmation Bias: Investors tend to only pay attention to information that supports their investment decisions while ignoring warning signs and risks that could cause prices to fall.
3. Overconfidence: Excessive confidence leads investors to overestimate their ability to predict the market, often making investment decisions without proper evaluation.

How to Avoid Investment Traps

1. Create a Clear Investment Plan: Before investing, set a plan that includes entry points, target returns, and your acceptable loss range. “If you’ve already lost the reason for holding a stock, you have even less reason to keep it.” Take myself for example — when I’m bullish on a stock, I set an expectation of over 10% returns, but I don’t necessarily sell at exactly 10%. Conversely, I’ll strategically buy more during dips. All of these decisions have my “reasons” behind them. Those reasons differ for everyone, but the key is whether you’re following your own investment strategy.

2. Diversify Your Investments: Don’t put all your money in a single stock or market. Diversified investing spreads risk. People always say “diversify your risk” — and with sufficient diversification, you can effectively reduce risk. Don’t chase hot stocks on hype. Make sure your portfolio is diversified enough and has adequate hedging capability.

3. Regularly Review Your Portfolio: Periodically review and adjust your portfolio to ensure it still aligns with your risk tolerance and investment goals. Although I check stock prices every day, it’s honestly just for fun — my investment strategy isn’t about short-term trading. But checking the market daily does help build confidence and improve my stock-picking intuition.

4. Learn to Stay Calm Through Market Swings: Finally, market ups and downs are unavoidable. We need to learn to take the long view and not make impulsive decisions based on short-term fluctuations. When I was younger, I went from small warrants → large warrants → large stock positions → all-in on futures → losing everything. All of this happened because I only cared about “profits” and had absolutely no investment strategy. I’d cash in gains when prices rose and cut losses in a panic when they fell. It wasn’t until I was utterly wiped out on futures that I finally realized: investing is actually quite simple.

Further Reading

Lazy Conclusion

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金融科技新創 CEO | 獨立財務顧問

Understanding and applying Prospect Theory may not necessarily make your stock investment strategy better. But by recognizing and learning to manage your own psychological biases, you can face market swings more calmly and make smarter investment decisions. Remember, successful investing isn’t just about picking the right stocks — more importantly, it’s about managing your own mindset.

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