Prospect Theory

Definition

Prospect Theory is a behavioral finance model that describes how individuals evaluate potential losses and gains when making decisions under risk. It highlights that people tend to be loss-averse, meaning they feel the pain of losses more intensely than the pleasure of equivalent gains, leading to irrational decision-making. This theory challenges traditional economic models that assume individuals act rationally and instead shows that psychological factors significantly influence financial choices.

5 Must Know Facts For Your Next Test

1. Prospect Theory was developed by psychologists Daniel Kahneman and Amos Tversky in 1979, fundamentally altering the understanding of decision-making under risk.
2. It introduces the concept of a value function, which is concave for gains and convex for losses, emphasizing that people are more sensitive to changes in wealth when those changes are near their current level.
3. The theory illustrates that individuals are often overconfident in their ability to predict future outcomes, which can lead to suboptimal financial decisions.
4. Prospect Theory has important implications for understanding market anomalies and investor behavior, showing why people may hold onto losing investments too long or sell winning investments too early.
5. It also explains why certain financial products, like insurance, are appealing even when they may not provide the best long-term value, due to the emotional weight given to potential losses.

Review Questions

• How does Prospect Theory redefine our understanding of risk in financial decision-making?
  • Prospect Theory redefines our understanding of risk by introducing the concept of loss aversion, which shows that individuals experience losses more intensely than gains. This means that when faced with risky decisions, people might avoid choices that could lead to potential losses even if those choices have better long-term outcomes. The theory also explains why investors often make irrational decisions based on emotional responses rather than objective analysis.
• Discuss the role of the framing effect in influencing investment decisions according to Prospect Theory.
  • The framing effect plays a crucial role in investment decisions as described by Prospect Theory. When information about potential gains or losses is presented differently, it can lead to different choices. For instance, if a stock 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. This demonstrates how people's reactions can change based on how options are framed, impacting their overall decision-making process.
• Evaluate how Prospect Theory can explain the behavior of investors during market downturns and its implications for financial strategies.
  • Prospect Theory helps explain investor behavior during market downturns by highlighting loss aversion and the tendency to panic sell. Investors often hold onto losing stocks too long due to the emotional pain associated with realizing a loss, leading to a phenomenon known as 'disposition effect.' This behavior can result in poorer financial strategies as investors miss opportunities to rebalance their portfolios effectively. Understanding this can lead to better investment approaches that account for psychological biases, encouraging more rational decision-making even during turbulent market conditions.

Related terms

Loss Aversion:

The tendency for individuals to prefer avoiding losses over acquiring equivalent gains; it suggests that losses have a greater emotional impact than an equivalent amount of gains.

Utility Function:

A mathematical representation of an individual's preferences, showing how they derive satisfaction or utility from different levels of wealth or outcomes.

Framing Effect: The phenomenon where people's decisions are influenced by how information is presented, leading to different choices depending on whether the outcomes are framed as gains or losses.