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What Is Prospect Theory?

Prospect theory is a cognitive theory in Behavioral Finance that describes how individuals make choices under conditions of risk and uncertainty, particularly when evaluating potential gains and losses. Developed by psychologists Daniel Kahneman and Amos Tversky, it posits that people assess the value of outcomes not in absolute terms, but relative to a specific reference point, typically their current wealth or status. A central tenet of prospect theory is Loss Aversion, which suggests that the psychological impact of a loss is roughly twice as powerful as the pleasure derived from an equivalent gain. This framework provides a more descriptively accurate model of human Decision-Making Process than traditional economic theories, explaining various seemingly irrational behaviors in financial contexts.

History and Origin

Prospect theory was introduced by Daniel Kahneman and Amos Tversky in their seminal paper "Prospect Theory: An Analysis of Decision under Risk," published in the journal Econometrica in 1979. Their work emerged from a series of experimental studies challenging the prevailing rational choice models of the time. The theory aimed to provide a more realistic account of human judgment and decision-making by incorporating psychological insights. This groundbreaking research, which demonstrated systematic deviations from rational behavior, earned Daniel Kahneman the Nobel Memorial Prize in Economic Sciences in 2002, shared with Vernon L. Smith for his work on experimental economics. The collaboration between Kahneman and Tversky significantly influenced the development of the field of behavioral economics, which examines the psychological factors influencing economic decisions.⁶

Key Takeaways

• Reference Dependence: Individuals evaluate outcomes as gains or losses relative to a specific reference point, not based on absolute wealth.
• Loss Aversion: The emotional impact of a loss is greater than the emotional impact of an equivalent gain.
• Diminishing Sensitivity: The marginal impact of both gains and losses decreases as their magnitude increases (e.g., the difference between gaining $10 and $20 feels larger than the difference between gaining $1,000 and $1,010).
• Probability Weighting: People tend to overweight small probabilities and underweight large probabilities, leading to distorted perceptions of risk.
• Descriptive, Not Prescriptive: Prospect theory describes how people actually make decisions, rather than prescribing how they should make them.

Interpreting Prospect Theory

Prospect theory posits a two-phase cognitive process for decision-making under risk: an editing phase and an evaluation phase. The editing phase involves framing outcomes and probabilities, often influenced by Heuristics and Cognitive Biases. For instance, the way a choice is presented (e.g., as a gain or a loss) can significantly alter preferences, a phenomenon known as the Framing Effect.

In the evaluation phase, individuals assign a "value" to each outcome based on a value function and "decision weights" to probabilities based on a weighting function. The value function is S-shaped: it is concave for gains (reflecting diminishing sensitivity to gains) and convex for losses (reflecting diminishing sensitivity to losses), and steeper for losses than for gains, illustrating loss aversion. The weighting function over-weights low probabilities and under-weights moderate and high probabilities. This means people might be overly optimistic about winning small jackpots or overly cautious about small risks, while being less sensitive to differences in higher probabilities. Understanding these functions helps interpret observed deviations from traditional rational choice models in various financial scenarios, from Investment Decisions to insurance choices.

Hypothetical Example

Consider an investor, Sarah, who purchased shares of Company X at $50 per share.

Scenario 1: Gains
The shares rise to $60. Sarah feels positive. If they then rise to $70, the additional pleasure she experiences is less than the pleasure she felt going from $50 to $60. This demonstrates diminishing sensitivity to gains.

Scenario 2: Losses
The shares fall to $40. Sarah feels significant pain, much more intense than the pleasure she felt gaining $10. This is an example of Loss Aversion. If the shares then fall to $30, the additional pain she experiences is less than the pain she felt going from $50 to $40, illustrating diminishing sensitivity to losses.

Scenario 3: Risk-Taking for Losses
Sarah's shares fall to $40. She faces a choice:

• Option A: Sell the shares now, realizing a sure $10 loss per share.
• Option B: Hold the shares, with a 50% chance they recover to $50 (no loss) and a 50% chance they fall to $30 (an additional $10 loss).

According to prospect theory, Sarah is more likely to choose Option B, even though it involves more risk. This is because people tend to be risk-seeking in the domain of losses, hoping to avoid a sure loss, which can lead to holding onto losing investments too long, a common Market Anomalies known as the disposition effect.

Practical Applications

Prospect theory has profound implications across various areas of finance and economics, helping to explain behaviors that classical economic models struggle to rationalize:

• Investment and Portfolio Management: It explains phenomena like the "disposition effect," where investors tend to sell winning stocks too early and hold losing stocks too long. This behavior is driven by the desire to realize gains and the aversion to realizing losses.⁵ Financial advisors often consider an investor's Risk Tolerance through the lens of prospect theory to understand their true appetite for risk, especially concerning potential losses.
• Financial Planning: Understanding loss aversion helps in designing retirement plans and savings schemes that encourage participation by minimizing the perception of potential losses or framing contributions as gains.
• Pricing and Marketing: Businesses can leverage prospect theory by framing prices and offers to appeal to customers' loss aversion or diminishing sensitivity. For instance, offering a discount for early payment (framing it as a gain) can be less effective than imposing a surcharge for late payment (framing it as avoiding a loss).
• Public Policy and Regulation: Governments and regulatory bodies, such as the U.S. Securities and Exchange Commission (SEC), recognize the influence of behavioral factors, including those explained by prospect theory, on investor decisions. This understanding informs policies aimed at protecting investors from their own biases.⁴ The field of behavioral economics, which prospect theory underpins, has informed policy initiatives, including the "nudge" concept, designed to guide individuals toward better choices.³

Limitations and Criticisms

While highly influential, prospect theory is not without its limitations and criticisms. Some critics argue that the theory provides a descriptive model without fully explaining the underlying psychological processes that lead to the observed behaviors. For example, it describes that people use a reference point but doesn't fully detail how this reference point is chosen or how it might shift.²

Another critique suggests that prospect theory, despite its advancements, may still offer a limited representation of human emotional and affective responses, particularly in more complex or dynamic decision environments. It primarily focuses on discrete, one-off decisions rather than continuous or interdependent choices. Furthermore, its empirical parameters (the shapes of the value and weighting functions) can vary widely depending on the context and individual, making universal predictions challenging. Some applications in the asset management industry suggest that while valuable, the complexity of real-world markets introduces factors beyond the direct scope of prospect theory.¹ For instance, other biases like the Endowment Effect or the Sunk Cost Fallacy also heavily influence decision-making and sometimes interact with the effects described by prospect theory.

Prospect Theory vs. Expected Utility Theory

Prospect theory is often contrasted with Expected Utility Theory, the traditional cornerstone of economic decision-making under risk.

While expected utility theory provides a normative ideal for rational economic agents, prospect theory offers a more empirically grounded explanation of human behavior, acknowledging the psychological biases that influence financial choices.

FAQs

What is the main idea behind prospect theory?

The main idea is that people make decisions under risk by evaluating potential outcomes as gains or losses relative to a reference point, not in terms of absolute wealth. They also tend to feel the pain of a loss more intensely than the pleasure of an equivalent gain, a concept known as Loss Aversion.

Who developed prospect theory?

Prospect theory was developed by two Israeli-American psychologists, Daniel Kahneman and Amos Tversky, and first published in 1979.

How does prospect theory apply to investing?

In investing, prospect theory helps explain why individuals might sell winning investments too quickly to "lock in" a gain, and hold onto losing investments for too long, hoping to avoid realizing a loss. This influences Investment Decisions and impacts Portfolio Management strategies.

What is the difference between prospect theory and rational choice theory?

Rational Choice Theory (including expected utility theory) assumes individuals make decisions based on logical reasoning to maximize their self-interest and utility, without emotional or psychological biases. Prospect theory, conversely, models actual human behavior, incorporating observed Cognitive Biases and psychological factors like loss aversion, which often lead to deviations from purely rational choices.

Can prospect theory help in everyday financial planning?

Yes, understanding prospect theory can inform everyday Financial Planning by making individuals aware of their inherent biases. For example, recognizing loss aversion can help prevent impulsive decisions to sell assets during market downturns or take excessive risks to avoid a small, certain loss. It also highlights the importance of how financial choices are framed to encourage better savings and spending habits.