Definition
Prospect Theory is a behavioral economic theory that describes the way people choose between probabilistic alternatives that involve risk, where the probabilities of outcomes are known. The theory suggests that people make decisions based on the potential value of losses and gains rather than the outcome, and that people evaluate these losses and gains using certain heuristics. The term was coined by Daniel Kahneman and Amos Tversky in 1979, ultimately earning Kahneman the Nobel Prize in Economics.
Key Takeaways
- Prospect Theory, proposed by Daniel Kahneman and Amos Tversky, illustrates how people decide between alternatives that involve risk like financial decisions. This theory asserts that people often do not behave rationally, contrary to traditional economic theories.
- Prospect Theory includes two main stages: editing and evaluation. During the editing phase, people decide how they perceive the options, while the evaluation phase involves choosing one based on perceived gains or losses. The theory suggests that the probability of an outcome and the value of potential loss or gain directly influence the decision-making process.
- The third main point is the concept of loss aversion inherent in the Prospect Theory. It refers to the human tendency to fear losses more than they value comparable gains. That is, people would rather avoid a loss than acquire an equivalent gain which drives most financial decisions.
Importance
Prospect Theory is a vital concept in behavioral finance that helps to understand how people make decisions involving uncertainties and risks.
It challenges traditional finance theories that assume that individuals are rational actors, by illustrating that people often make decisions based on potential gains and losses, not just final outcomes.
The theory asserts that people’s perceptions of gains and losses play a more significant role in determining choices rather than the final outcome, showing a tendency of risk-aversion when faced with potential gains, and risk-seeking when dealing with potential losses.
This can greatly impact financial decision making, portfolio management, and market trends.
Understanding Prospect Theory is important as it provides a more realistic lens through which to view investor behavior, emotional bias, and decision-making, thus influencing finance strategies and policies.
Explanation
Prospect Theory addresses the way people make decisions involving risk, particularly financial decisions, by offering an alternative to the traditional utility theory. It was developed by psychologists Daniel Kahneman and Amos Tversky in 1979 as a psychologically more accurate description of how people evaluate potential gains and losses.
The fundamental purpose of Prospect Theory is to model the human decision making process more accurately than traditional utility theory, in a way that reflects the cognitive processes and biases which can influence financial decisions. The main application of Prospect Theory lies in the realm of economics and finance, specifically within behavioral finance.
It serves as a vital tool in understanding and predicting the choices people make under uncertainty. The theory helps economists, financial analysts, marketers, and decision-makers better understand why people take certain risks and avoid others, often defying statistics and traditional economic predictions.
It provides insights into observed irrational behavior within markets and can be used to help optimize financial decision making processes by taking into account how people actually perceive and evaluate risk.
Examples of Prospect Theory
Prospect Theory, introduced by psychologists Daniel Kahneman and Amos Tversky, suggests that investors and consumers make decisions based on the potential value of losses and gains rather than the final outcome. Here are three real-world examples:
Lottery Ticket Purchase: Despite the small probability of winning, many people buy lottery tickets. This behavior is explained by the Prospect Theory as people tend to overweight small probabilities of winning and are attracted by the large gain. The potential joy from winning overpowers the small loss from buying the ticket.
Investing in Stock Market: Imagine an investor with a portfolio of stocks. If market prices drop, according to prospect theory, this investor is more likely to hold onto the stocks hoping the prices will rise again to avoid the psychological pain of realizing a loss. On the other hand, if the stocks rise, the investor may be quick to sell and realize their gains due to the fear of losing the unrealized gains.
Insurance: Despite the low probability of facing a severe accident or a house fire, people buy insurance policies. According to the prospect theory, people overweight the potential significant loss of such events and thus willingly pay for insurance to prevent them, even if the likelihood of these events occurring is small.
FAQ: Prospect Theory
What is Prospect Theory?
Prospect Theory is a behavioral model that explains how people decide between alternatives that involve risk and uncertainty (e.g., % chances of gains or losses). It states that people make decisions based on the potential value of losses and gains rather than the final outcome, and that people evaluate these losses and gains using certain heuristics. This theory is developed by Daniel Kahneman and Amos Tversky in 1979.
Why is Prospect Theory important?
Prospect Theory is important because it provides insight into how people behave when faced with uncertainty. It helps us understand why people often make irrational financial decisions and provides a framework for understanding and predicting these types of decisions.
How does Prospect Theory work?
Prospect Theory works on two concepts: the value function and the weighting function. The value function refers to how people value their losses and gains. According to the theory, losses have a greater impact on people than an equal amount of gain. The weighting function refers to the likelihood of a gain or loss. People tend to overweight unlikely events but underweight likely ones.
What are some applications of Prospect Theory?
Prospect Theory is primarily used in economics and finance, particularly in areas such as investment and trading where decision-making under uncertainty is crucial. It’s also used in fields such as marketing and management, helping to predict consumer and employee behavior.
How does Prospect Theory differ from Expected Utility Theory?
Prospect Theory differs from Expected Utility Theory in that the latter assumes that individuals behave rationally and always make the most optimal financial decisions. Prospect Theory, on the other hand, recognizes that people often make irrational decisions when faced with potential gains and losses.
Related Entrepreneurship Terms
- Behavioral Finance
- Loss Aversion
- Utility Theory
- Risk Perception
- Decision Theory
Sources for More Information
- Investopedia – Provides in-depth analysis and explanations of various finance-related terms including Prospect Theory.
- Corporate Finance Institute – Offers online courses and educational materials on different finance concepts including Prospect Theory.
- Financial Times – Frequently publishes articles relevant to different finance practices, including Prospect Theory.
- Behavioral Economics – A great website that explains about behavioral finance concepts such as Prospect Theory.
