What Is Prospect Theory?
Prospect theory is a foundational theory within behavioral finance that describes how individuals make decision-making under risk and uncertainty. Developed by psychologists Daniel Kahneman and Amos Tversky, it posits that people evaluate potential outcomes in terms of gains and losses relative to a specific reference point, rather than in terms of final wealth or absolute outcomes. This framework explains observed deviations from the predictions of traditional rationality models in economics, highlighting the influence of psychological factors on financial choices. Prospect theory suggests that individuals exhibit differing attitudes toward risk depending on whether they perceive an outcome as a gain or a loss.
History and Origin
Prospect theory was introduced by Daniel Kahneman and Amos Tversky in their seminal 1979 paper, "Prospect Theory: An Analysis of Decision Under Risk," published in the journal Econometrica.4 Prior to this, the prevailing model for understanding choices under uncertainty was expected utility theory, which assumed that individuals make decisions to maximize their overall utility based on objective probabilities and outcomes. Kahneman and Tversky, both psychologists, observed that people's actual decision-making often contradicted this rational framework.
Their work emerged from extensive empirical research and experiments that revealed systematic cognitive biases in human judgment. In 2002, Daniel Kahneman was awarded the Nobel Memorial Prize in Economic Sciences, in part, for his and Tversky's integration of psychological insights into economic science, particularly for their work on prospect theory. Although Amos Tversky passed away in 1996, his profound contributions were acknowledged posthumously.
Key Takeaways
- Prospect theory describes how individuals make choices under risk, focusing on gains and losses relative to a reference point, rather than absolute wealth.
- It highlights loss aversion, where the psychological impact of a loss is felt more intensely than the pleasure of an equivalent gain.
- The theory incorporates diminishing sensitivity to changes in wealth, meaning the impact of a gain or loss lessens as its magnitude increases away from the reference point.
- It explains phenomena like the framing effect, where the presentation of options influences choices even if the underlying outcomes are objectively the same.
- Prospect theory provides a descriptive model of behavior, offering insights into real-world financial anomalies that traditional economic models often struggle to explain.
Interpreting Prospect Theory
Prospect theory offers a powerful lens through which to interpret human behavior in financial contexts, particularly in situations involving risk and uncertainty. Unlike models that assume perfectly rationality, prospect theory suggests that individuals process information and make choices based on subjective perceptions of gains and losses. This framework illuminates why people might exhibit risk aversion for potential gains but become risk-seeking when facing potential losses.
A central tenet of prospect theory is loss aversion. This means that the pain of losing a certain amount is psychologically more potent than the pleasure of gaining the same amount. For instance, the negative feeling associated with losing $100 might be twice as strong as the positive feeling of gaining $100. This asymmetry influences a wide range of financial decisions, from investing to insurance choices. Additionally, the concept of diminishing sensitivity implies that the marginal impact of a gain or loss decreases as its distance from the reference point increases. For example, the difference between gaining $10 and $20 feels more significant than the difference between gaining $1,000 and $1,010.
Hypothetical Example
Consider an investor, Sarah, who purchased 100 shares of Company X at $50 per share. Her reference point for this investment is her purchase price.
Scenario 1: Gains
The stock price rises to $60 per share. Sarah now has a paper gain of $1,000. According to prospect theory, she might become risk-averse regarding this gain. If she's offered a choice between selling the stock now for a sure $1,000 profit or holding it with a 50% chance of gaining another $500 (total $1,500) and a 50% chance of the price falling back to $50 (total $0 gain), she is likely to choose the sure $1,000 profit. Her utility function for gains is concave, meaning the additional satisfaction from an extra $500 gain decreases.
Scenario 2: Losses
The stock price falls to $40 per share. Sarah now has a paper loss of $1,000. In this domain of losses, prospect theory suggests she might become risk-seeking. If she's offered a choice between selling the stock now for a sure $1,000 loss or holding it with a 50% chance of it recovering to $50 (total $0 loss) and a 50% chance of falling further to $30 (total $2,000 loss), she might choose to hold, hoping to avoid the certain loss. Her value function for losses is convex, meaning she's willing to take on more risk to avoid realizing a loss, demonstrating the concept of loss aversion.
Practical Applications
Prospect theory has numerous practical applications across finance and economics, offering insights into various market phenomena and investor behaviors that traditional models often fail to explain.
- Investment Decisions: Understanding loss aversion helps explain why investors might hold onto losing stocks for too long (hoping they'll rebound) and sell winning stocks too soon (to lock in a gain), a phenomenon known as the disposition effect. This can lead to suboptimal investment strategy outcomes.
- Market Bubbles and Crashes: The principles of prospect theory, combined with heuristics like herd mentality and overconfidence, can shed light on the formation and bursting of financial bubbles. During periods of euphoria, investors may become overly optimistic, driving prices beyond fundamental values, as seen during the dot-com bubble in the late 1990s.3 The fear of missing out (FOMO) also plays a significant role, where individuals, seeing others profit, jump into investments without adequate analysis, contributing to irrational exuberance.2
- Product Design in Finance: Financial institutions can design products and communication strategies that account for these biases. For example, framing insurance policies in terms of avoiding potential losses rather than securing gains can make them more appealing.
- Regulatory Efforts: Regulatory bodies, such as the U.S. Securities and Exchange Commission (SEC), acknowledge the impact of behavioral biases on investor behavior. The SEC's Office of Investor Education and Advocacy has published reports identifying common investing mistakes stemming from these biases, including active trading, the disposition effect, and inadequate portfolio diversification.1
- Financial Counseling: Financial advisors utilize principles from behavioral finance to help clients identify and mitigate their own biases, leading to more disciplined and effective financial planning.
Limitations and Criticisms
While prospect theory provides a robust descriptive account of human decision-making under risk, it also faces certain limitations and criticisms. One challenge is its complexity in predicting behavior across all possible scenarios, as individual reference point determination can be highly subjective and context-dependent. What constitutes a "gain" or "loss" can vary significantly among individuals and situations, making precise predictions difficult.
Critics also point out that while prospect theory excels at describing how people behave, it does not always fully explain why certain biases, like loss aversion, exist or consistently manifest. Furthermore, some researchers argue that the theory's focus on individual preferences might not fully capture the dynamics of complex market interactions, where collective behaviors and market structures also play significant roles, potentially overshadowing individual cognitive biases.
Another critique revolves around the generalizability of experimental findings, on which prospect theory heavily relies. While controlled experiments provide strong evidence for the existence of these biases, their applicability to real-world, high-stakes financial environments is sometimes debated. Despite these points, prospect theory remains a cornerstone of behavioral economics and continues to evolve, with extensions like cumulative prospect theory attempting to address some of its earlier limitations.
Prospect Theory vs. Expected Utility Theory
Prospect theory and expected utility theory represent two distinct approaches to modeling decision-making under risk. The primary difference lies in their underlying assumptions about human rationality and how outcomes are evaluated.
| Feature | Prospect Theory | Expected Utility Theory |
|---|---|---|
| Foundation | Descriptive; based on psychological observations of actual behavior. | Normative; based on axioms of rational choice. |
| Outcome Evaluation | Evaluates outcomes as gains or losses relative to a reference point. | Evaluates outcomes based on final wealth or absolute utility function. |
| Risk Attitudes | Risk-averse for gains, risk-seeking for losses (due to loss aversion and diminishing sensitivity). | Generally assumes consistent risk aversion, or risk neutrality/seeking, across all outcomes. |
| Probabilities | Uses subjective decision weights, which may overweight small probabilities and underweight large ones. | Uses objective probabilities. |
While expected utility theory describes how a perfectly rational agent should make decisions, prospect theory explains how real individuals actually make decisions, often deviating from strict rationality. The confusion between the two often arises when people expect investors to always act in a purely logical, wealth-maximizing manner, whereas prospect theory demonstrates that psychological factors, emotions, and the framing of choices significantly influence financial outcomes.
FAQs
What is the core idea of prospect theory?
The core idea of prospect theory is that people evaluate financial outcomes (gains and losses) relative to a flexible reference point, rather than based on their absolute wealth. It suggests that individuals exhibit loss aversion, meaning the pain of a loss is felt more intensely than the pleasure of an equivalent gain.
Who developed prospect theory?
Prospect theory was developed by two psychologists, Daniel Kahneman and Amos Tversky, in the late 1970s. Their work revolutionized the field of behavioral economics by integrating psychological insights into economic decision-making.
How does prospect theory explain irrational behavior?
Prospect theory explains seemingly irrational financial behavior by highlighting psychological biases such as loss aversion, diminishing sensitivity, and the framing effect. These biases can lead individuals to make choices that do not maximize their objective expected utility, such as taking on more risk to avoid a loss or selling winners too early.
What is an example of prospect theory in action?
A common example is the "disposition effect," where investors tend to sell investments that have gained value too quickly while holding onto investments that have lost value for too long. This behavior is driven by loss aversion (reluctance to realize a loss) and risk-seeking in the domain of losses (hoping for a rebound).