Behavioral Finance
Prospect theory as the backbone
Behavioral finance replaces the rational-agent assumption with descriptive models of choice. Prospect theory holds that people evaluate outcomes as gains or losses relative to a reference point, are risk-averse over gains, risk-seeking over losses, and weigh losses roughly twice as heavily as equivalent gains (loss aversion). Probability weighting overweights small probabilities and underweights moderate ones, which explains both lottery-like speculation and insurance buying.
The biases candidates must name
Overconfidence produces overtrading, narrow diversification, and underestimated risk. The disposition effect is the tendency to sell winners too early and hold losers too long; it is a joint product of loss aversion and mental accounting, not loss aversion alone. Anchoring fixates on a reference price such as the purchase price. Representativeness extrapolates recent performance into the future. Availability overweights vivid, recent events. Confirmation bias filters evidence. Herding and fear of regret drive momentum in flows. Framing changes choices without changing the underlying payoffs.
Traps and a worked example
Questions often blur the disposition effect with loss aversion, or claim prospect theory implies uniform risk aversion. It does not: curvature flips across the reference point. Another trap is confusing the house-money effect with pure loss aversion.
Worked example: a coin flip paying +$150 or -$100 has expected value +$25. Most people still refuse. Loss aversion of about 2.25 predicts rejection whenever the gain is less than roughly 2.25 times the loss; here 150/100 = 1.5, below the threshold, so rejection is the predicted response despite positive expected value. The rule of thumb: quote the gain-to-loss ratio and compare it to the loss-aversion coefficient before concluding a choice is irrational.