Prospect Theorybehavioral

Prospect Theory is a behavioral economics theory describing how people make decisions under risk by evaluating gains and losses relative to a reference point, with losses weighing more than gains and probabilities weighted nonlinearly.

Overview

Prospect Theory, introduced by Daniel Kahneman and Amos Tversky in 1979, describes how people evaluate potential gains and losses relative to a personal reference point, rather than against final outcomes. It identifies key departures from classical expected utility theory.

Core ideas

Reference point: outcomes are judged relative to a baseline; gains and losses are not symmetric.
Loss aversion: losses are felt more intensely than equivalent gains.
Value function: defined for gains and losses with diminishing sensitivity and steeper losses.
Probability weighting: people tend to overweight small probabilities and underweight large ones, which can shape risk taking.

In finance and behavior

The theory helps explain why investors may hold losing investments too long or take on more risk after gains, and why the framing of information can alter choices. It is a foundational element of behavioral finance and informs understanding of risk communication and insurance decisions.

Limitations and extensions

Original prospect theory has extensions, such as cumulative prospect theory, to address some empirical issues and to handle a broader range of decision contexts. Real-world behavior can vary across individuals and situations.

Example Usage

In a study, participants may prefer a lottery with a small chance of a large payoff over a certain smaller payoff, illustrating overweighting of small probabilities and loss-averse framing.

Related Terms

Loss aversion · Reference point · Probability weighting · Value function · Cumulative prospect theory · Behavioral finance · Framing effect