What is Prospect Theory?
399 reads · Last updated: December 5, 2024
Prospect theory assumes that losses and gains are valued differently, and thus individuals make decisions based on perceived gains instead of perceived losses. Also known as the "loss-aversion" theory, the general concept is that if two choices are put before an individual, both equal, with one presented in terms of potential gains and the other in terms of possible losses, the former option will be chosen.
Definition
Prospect Theory suggests that losses and gains are valued differently, leading individuals to prefer potential gains over avoiding potential losses in decision-making processes. Also known as the 'loss aversion' theory, it posits that if individuals are given two equal choices, one framed in terms of potential gains and the other in terms of potential losses, they are more likely to choose the former.
Origin
Prospect Theory was first introduced by Daniel Kahneman and Amos Tversky in 1979. Through a series of experimental studies, they found that traditional expected utility theory could not adequately explain people's actual decision-making behavior under risk, leading them to propose Prospect Theory to better describe and predict these behaviors.
Categories and Features
Prospect Theory is divided into two main phases: the editing phase and the evaluation phase. In the editing phase, individuals preliminarily analyze and simplify choices. In the evaluation phase, individuals assess choices based on different weights assigned to potential gains and losses. A key feature of Prospect Theory is 'loss aversion,' meaning people are generally more sensitive to losses than to gains.
Case Studies
A typical case is investor behavior in the stock market. During market fluctuations, investors often prefer to hold onto losing stocks rather than sell them, hoping for future market rebounds to yield gains rather than immediately acknowledging losses. Another case is insurance purchasing behavior, where people are willing to pay high premiums to avoid potential large losses, even if the probability of such losses is low.
Common Issues
Common issues investors face when applying Prospect Theory include overconfidence and overreaction, which can lead to irrational investment decisions. Additionally, misunderstanding the degree of loss aversion may result in excessive risk avoidance, potentially missing out on investment opportunities.
