Prospect theory is a behavioral theory in economics which describes the way in which people tend to choose between probabilistic alternatives that involve risk and cases where the probabilities of outcomes are known. According to this theory, people- in this case forex traders make decisions based on the latent value of losses and gains rather than the ultimate outcome foreseen. Practically speaking, it seems all too justified to expect a forex trader to prefer a sure investment rather than an unsure one, however what Prospect theory suggests is that traders reserve specific quantifiable emotions over losses and gains separately for each one.
Loss Aversion
Loss aversion refers to people's inclination to avoiding losses rather than acquiring gains, psychologically speaking, a lot of studies show that losses are more powerful than gains however due to human psyche and greed, when traders evaluate an outcome comprising parallel gains and losses, they prefer avoiding losses rather than making gains.
The Endowment Effect
Accordingly, originally, loss aversion was proposed as a justification of the endowment effect, which is the fact that people place a higher value on a good that they own than on an identical good that they do not own, as is the human psyche. Loss aversion and the endowment effect go against the Coase theorem which states that "the allocation of resources will be independent of the assignment of property rights when costless trades are possible.”
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