The Concept of a Reference Point in Prospect Theory

Kahneman and Tversky’s Prospect Theory introduces an interesting concept called the Reference Point. The idea is pretty simple: we don’t evaluate prices, gains, and losses in absolute terms. We judge them relative to a mental reference point.

For example, someone who bought Bitcoin at $70K sees the market differently from someone who bought at $40K. And someone who doesn’t own Bitcoin at all will have a completely different perspective.

So the exact same price can have three completely different meanings for three different people.

And the important part is that your reference point isn’t necessarily your purchase price. It could be the previous high, an expected price, yesterday’s price, or even a price you simply consider “reasonable.”

This is where markets get interesting. At $85K, one person might say: “It's already expensive. A correction is coming.”

Another might say: “The trend is bullish. If $85K has been established as support, why should I wait for $65K?”

They’re looking at the exact same chart, but from different mental reference points.

Even two people who bought at exactly the same price can make completely different decisions at the same market price if their time horizons and scenarios are different.

That’s why the question of “Where should I buy?” doesn’t necessarily have the same answer for a long-term investor and a short-term trader.

Sometimes, what we call “expensive” or “cheap” says less about the price itself and more about the reference point in our own heads. And the market, of course, has no obligation to align with it.

There’s also an interesting connection here with an old idea from the Austrian School of Economics: value is not an inherent and fixed property of a good. It depends on individual subjective judgment.

Carl Menger approached value from this perspective: the value of a good comes from its relationship with human needs and preferences, rather than from some objective “intrinsic value” embedded in the good itself.

So before asking:
“Is this asset expensive or cheap?”
Maybe we should ask:
“Expensive or cheap relative to what?”

Because very often, what we call “expensive” or “cheap” isn’t an absolute property of the price.
It’s the result of the reference point we’ve constructed in our own minds.

Prospect Theory — Kahneman & Tversky
Reference-Point Effects — ScienceDirect

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