Prospect Theory in Behavioral Finance

The Prospect Theory was originally conceived by Kahneman and Tversky (1979) and later resulted in Daniel Kahneman being awarded the Nobel Prize for Economics. The work by the authors is considered as path breaking in behavioral finance. They introduced the concept of prospect theory for the analysis of decision making under risk. This theory is considered to be seminal in the literature of behavioral finance. It was developed as an alternative model for expected utility theory. It throws light on how individual evaluate gain or losses. The prospect theory has three key aspects.

  1. People sometimes exhibit risk aversion and sometimes risk loving behaviors depending on the nature of the prospect. This is due to the fact that people give lower weight age to the outcomes which are probable as compared to those that are certain. This makes them risk averse for choices with sure gains while risk seekers for choices with sure losses.
  2. People assign value to losses or gains rather than final assets. Here two thought processes come into play. These are editing and evaluation. During the editing stage the prospects are ranked as per the rules of thumb (heuristics) and in evaluation stage some reference point is taken into account that provides a relative basis for determining gain or loses
  3. The weight age given to losses is higher than given to gains of the same amount this is because people are averse to losses as they loom large than gains this is called loss aversion.

The value function in the prospect theory replaces the utility function in the expected utility theory. Further instead of using simple probabilities as in the expected utility theory it uses decision weights which are a function of probability. The following figure shows the value function of the prospect theory the S-shaped value function depicted in the figure is the central element of the prospect theory.

Prospect Theory in Behavioral Finance

The shape of the S shaped valued function is concave in the region of gain and convex in the loss region reflecting risk aversion in the domain of gains and risk seeking in the domain of losses. The interesting property of the value function is that it is steepest at the reference point. It implies that a given change in gains or losses has a smaller effect on the value experienced by an investor when the distance to the reference point is large. Prospect theory maintains that when choosing between gambles people compare the gain and losses for each one and selects the one with the highest perspective utility. This argument indicates that people may choose a portfolio allocation by computing for each allocation the potential gains and losses in the value of their holdings and then taking the allocation with the highest prospective utility. Prospect theory has another element relating to weighing function. The value of each outcome is multiplied by decision weight. Decision weight measures the impact of events on the desirability of an investment. Kahneman and Tversky call this property as sub certainly decision weight age generally repressive with respect to true probabilities implying that preferences are less sensitive to variations in probability than the rational benchmark would suggest. Prospect theory describes several states of mind that can be expected to influences on individuals decision making process.

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