Prospect Theory

Definition

Prospect theory is a behavioral finance concept that describes how individuals make decisions based on the potential value of losses and gains rather than the final outcome. It highlights that people are more sensitive to losses than to gains, which leads to risk-averse behavior when faced with potential gains and risk-seeking behavior when faced with potential losses. This theory fundamentally challenges traditional economic theories that assume individuals are rational decision-makers who always seek to maximize utility.

5 Must Know Facts For Your Next Test

1. Prospect theory was developed by Daniel Kahneman and Amos Tversky in 1979 as a way to explain inconsistencies in traditional economic theory regarding human decision-making.
2. One key principle of prospect theory is the value function, which is concave for gains and convex for losses, indicating diminishing sensitivity to changes in wealth.
3. People tend to evaluate outcomes relative to a reference point, which can significantly affect their perceptions of gains and losses.
4. Prospect theory has important implications for understanding market anomalies and investor behavior, showing that emotions and cognitive biases influence financial decisions.
5. It explains why individuals may hold onto losing investments longer than they should (loss aversion) while selling winning investments too soon (risk aversion).

Review Questions

• How does prospect theory explain the tendency of investors to exhibit loss aversion when making financial decisions?
  • Prospect theory explains loss aversion by illustrating that individuals place greater weight on potential losses compared to equivalent gains. This means that when faced with an investment that may lose value, investors often hold onto it longer than rational analysis would suggest because the pain of realizing a loss outweighs the potential benefit of selling at a gain. As a result, they may choose to avoid selling losing investments, hoping for a turnaround instead of making the more rational choice of cutting losses.
• Discuss how the framing effect relates to prospect theory and influences investor behavior in financial markets.
  • The framing effect is closely related to prospect theory as it shows how the presentation of choices can lead to different decisions based on perceived outcomes. For example, if an investment is framed as having a 70% chance of success versus a 30% chance of failure, investors may be more inclined to take the risk despite both statements conveying the same information. This effect highlights how psychological factors play a crucial role in decision-making, demonstrating that investors do not always act in accordance with rational utility maximization but are influenced by how options are framed.
• Evaluate the significance of prospect theory in understanding behavioral finance compared to traditional utility theory.
  • Prospect theory significantly reshapes our understanding of behavioral finance by challenging the assumptions made by traditional utility theory about rational decision-making. Unlike utility theory, which posits that individuals consistently act to maximize their utility without bias, prospect theory recognizes that emotions and cognitive biases heavily influence choices. This understanding helps explain market anomalies and investor behaviors that seem irrational under traditional models, such as overreaction to losses or underreaction to gains, allowing for more accurate predictions and insights into market dynamics.

Related terms

Loss Aversion: Loss aversion refers to the tendency for people to prefer avoiding losses over acquiring equivalent gains, meaning that the pain of losing is psychologically more powerful than the pleasure of gaining.

Framing Effect: The framing effect describes how people's choices can be influenced by how options are presented or 'framed,' often leading to different decisions based on the same information.

Utility Theory: Utility theory is a classical economic theory that suggests individuals make decisions to maximize their overall satisfaction or utility, assuming rational behavior in evaluating outcomes.