Investors risk tolerance is asymmetric

Prospect theory finds Investors risk tolerance is asymmetric. Investors feel the pain of loss twice as much as the pleasure from gain.

Prospect Theory finds that investors are Loss Averse; they tend to experience more negative feelings when they lose money than they do positive feelings when they gain. In fact, Prospect Theory finds that investors feel the pain of loss more than twice as much as they feel the pleasure of gains.

Investors dislike a -20% loss more than they like a 40% gain. Below is the graph from “Prospect Theory” showing how gains /losses are convex or concave.

Prospect theory is a behavioral finance theory that describes the way people choose between probabilistic alternatives that involve risk, where the probabilities of outcomes are unknown.

Loss aversion: In cognitive psychology and decision theory, loss aversion refers to people’s tendency to prefer avoiding losses to acquiring equivalent gains: it is better to not lose $5 than to find $5. The principle is very prominent in behavioral finance.

In fact, investors are risk-averse when it comes to their gains, so the function is concave. They want to lock in their gains and not give them back. Investors are risk seeking when it comes to their losses. They are willing to take more risk of loss in hopes the loss comes back to breakeven.