Prospect theory is a behavioral economics theory that was first proposed by psychologists Daniel Kahneman and Amos Tversky in 1979. The theory suggests that individuals do not make decisions based solely on the expected value of different outcomes, but rather on the potential gains and losses associated with those outcomes.
According to prospect theory, individuals evaluate potential gains and losses asymmetrically. Specifically, individuals experience the pain of a loss more acutely than the pleasure of an equivalent gain. This phenomenon is known as loss aversion.
In addition to loss aversion, prospect theory also suggests that individuals evaluate potential outcomes in terms of reference points. Reference points are the starting points from which individuals evaluate gains and losses. For example, if an individual is considering an investment that could result in a gain of $100,000, they may evaluate that gain differently depending on their reference point. If their current financial situation is dire, the potential gain may be evaluated more positively than if they were already financially comfortable.
Prospect theory also suggests that individuals are more likely to take risks when evaluating potential losses, rather than potential gains. This phenomenon is known as risk-seeking behavior. For example, individuals may be more willing to take on high-risk investments when facing potential losses, rather than when facing potential gains.
The implications of prospect theory are significant for investors and financial professionals. By understanding the cognitive biases and tendencies associated with prospect theory, investors can make more informed decisions and reduce the impact of these biases on their portfolios. Financial professionals can also use prospect theory to develop investment strategies that account for the asymmetric evaluation of gains and losses.
In conclusion, prospect theory is a behavioral economics theory that suggests individuals evaluate potential gains and losses asymmetrically, with loss aversion being a key factor. Understanding the cognitive biases associated with prospect theory can help investors make more informed decisions and reduce the impact of these biases on their portfolios. Financial professionals can also use prospect theory to develop investment strategies that account for the asymmetric evaluation of gains and losses.