Prospect theory

Definition

Prospect theory is a behavioral economic theory that describes how individuals evaluate potential losses and gains when making decisions under risk. It suggests that people are more sensitive to losses than to equivalent gains, leading to irrational decision-making influenced by emotions and biases rather than objective probability. This theory explains why investors might hold onto losing stocks for too long, hoping for a rebound, while being quick to sell winning stocks to secure profits.

5 Must Know Facts For Your Next Test

1. Prospect theory was developed by psychologists Daniel Kahneman and Amos Tversky in 1979 as an alternative to classical utility theory, emphasizing psychological factors in decision-making.
2. It introduces a value function that is concave for gains and convex for losses, reflecting the diminishing sensitivity to changes as people move further from a reference point.
3. The theory posits that individuals use a reference point (often the status quo) when evaluating outcomes, leading to different perceptions of value based on whether they experience gains or losses.
4. Prospect theory can explain various market phenomena, including why investors may behave irrationally during periods of volatility, often driven by emotional responses rather than logical assessments.
5. The concept of loss aversion implies that investors are likely to engage in risky behavior to avoid losses, impacting their portfolio management strategies and overall financial decision-making.

Review Questions

• How does prospect theory explain the tendency for investors to hold onto losing stocks longer than winning ones?
  • Prospect theory highlights the concept of loss aversion, which states that individuals feel the pain of a loss more intensely than the pleasure of a gain. This leads investors to hold onto losing stocks in hopes of recovering their initial investment, fearing the emotional impact of realizing a loss. In contrast, they may sell winning stocks quickly to lock in profits, avoiding the risk of loss should those stocks decline in value.
• Discuss how framing effects can impact financial decisions according to prospect theory.
  • Framing effects demonstrate how the presentation of information can significantly influence decision-making. According to prospect theory, if a financial outcome is framed as a potential gain, individuals may perceive it more positively and make riskier choices. Conversely, if the same outcome is framed as a potential loss, individuals tend to be more conservative in their decisions. This shows that context and wording can shape how investors assess risks and returns, ultimately affecting their financial strategies.
• Evaluate the implications of prospect theory for understanding market behavior during economic downturns.
  • Prospect theory provides valuable insights into market behavior during economic downturns by emphasizing the psychological factors that drive investor decisions. When faced with potential losses, investors may react irrationally due to heightened loss aversion, leading them to sell off assets quickly or hold onto failing investments in hopes of recovery. This behavior can exacerbate market volatility and create feedback loops where fear drives further declines. Understanding these dynamics helps explain how emotional responses can lead to larger market movements and affect overall economic stability.

Related terms

loss aversion:

A concept within prospect theory that indicates individuals prefer to avoid losses rather than acquiring equivalent gains, meaning the pain of losing is psychologically more impactful than the pleasure of gaining.

framing effect: A cognitive bias where individuals make different decisions based on how information is presented, highlighting the influence of context on perception and choice.

certainty effect: A phenomenon where people tend to overweight outcomes that are certain, compared to those that are merely probable, leading them to make decisions that may not align with expected utility theory.