Prospect Theory

What is the 'Prospect Theory'

The prospect theory is a theory that people value gains and losses differently and, as such, will base decisions on perceived gains rather than perceived losses. Thus, if a person were given two equal choices, one expressed in terms of possible gains and the other in possible losses, people would choose the former.

Also known as "loss-aversion theory."

BREAKING DOWN 'Prospect Theory'

To demonstrate, say one investor was presented with the same mutual fund by two different financial advisors. The first tells the investor that the mutual fund has had an average return of 7% over the past five years. The second advisor tells the investor that the mutual fund has seen above-average returns in the past 10 years but has been declining in recent years. According to prospect theory, even though the investor is presented with the same mutual fund, he or she is more likely to buy the mutual fund from the first advisor, who expressed the rate of return as an overall 7% gain, rather a combination of both high returns and losses.

RELATED TERMS
  1. Biased Expectations Theory

    A theory that the future value of interest rates is equal to ...
  2. Mutual Fund

    An investment vehicle that is made up of a pool of funds collected ...
  3. Accelerator Theory

    An economic theory that suggests that as demand or income increases ...
  4. Mutual Fund Liquidity Ratio

    A ratio published monthly by the Investment Company Institute ...
  5. Dow Theory

    A theory which says the market is in an upward trend if one of ...
  6. Demand Theory

    A theory relating to the relationship between consumer demand ...
Related Articles
  1. Trading

    7 Controversial Investing Theories

    We take a closer look at the theories that attempt to explain and influence the market.
  2. Trading

    Behavioral Finance: Key Concepts - Prospect Theory

    By Albert PhungKey Concept No.8: Prospect Theory Traditionally, it is believed the net effect of the gains and losses involved with each choice are combined to present an overall evaluation of ...
  3. Financial Advisor

    5 Reasons Financial Advisors Still Choose Mutual Funds

    Take a look at five primary reasons why financial advisors still choose to recommend mutual funds over other types of investment vehicles.
  4. ETFs & Mutual Funds

    4 Mistakes to Avoid When Choosing Mutual Funds to Invest in

    Mutual funds are a great way to build wealth but not all of them are the same. Investors have to be mindful of fees, turnover, redundancy and performance.
  5. ETFs & Mutual Funds

    A Mutual Funds Guide for Young Investors

    Learn how mutual funds work, why they are so popular and how younger investors can get started by putting mutual funds in their IRAs or 401(k)s.
  6. ETFs & Mutual Funds

    Mutual Fund Basics Tutorial

    Learn about the basics - and the pitfalls - of investing in mutual funds.
  7. Investing

    Advising FAs: Explaining Mutual Funds to a Client

    More than 80 million people, or half of the households in America, invest in mutual funds. No matter what type of investor you are, there is bound to be a mutual fund that fits your style.
  8. Financial Advisor

    Mutual Funds: How Many is Too Many? (VTSMX, VBMFX)

    How many mutual funds are too many when it comes to a well diversified portfolio?
  9. ETFs & Mutual Funds

    How to Rate Your Mutual Fund Manager

    What to really look for when you're deciding on a mutual fund.
  10. ETFs & Mutual Funds

    AMECX: Income Fund of America Performance Case Study

    Learn about The Income Fund of America, including an information overview, a historical look at the fund's returns and trend analysis over the past five years.
RELATED FAQS
  1. How does behavioral economics treat risk aversion?

    Learn about the relationship between decision-making and risk, as described by one of the foundational theories in behavioral ... Read Answer >>
  2. How often do mutual funds pay capital gains?

    Find out how often mutual funds distribute capital gains income, including the basics of how mutual funds work and why frequent ... Read Answer >>
  3. What's the difference between agency theory and stakeholder theory?

    Learn how agency theory and stakeholder theory are used in business to understand common business communication problems ... Read Answer >>
  4. How do you find out the price of a mutual fund?

    The easiest way to find out the price of a mutual fund is to look at its net asset value (NAV). NAV is the total value of ... Read Answer >>
  5. Why is it that when investors realize returns on a mutual fund, its price tends to ...

    Mutual funds have been in existence since 1924, when the first open-ended mutual fund was created. Since then, the market ... Read Answer >>
  6. How do I judge a mutual fund's performance?

    Evaluate mutual fund performance utilizing resources such as Morningstar; compare the fund with others in its peer group ... Read Answer >>
Hot Definitions
  1. Dove

    An economic policy advisor who promotes monetary policies that involve the maintenance of low interest rates, believing that ...
  2. Cyclical Stock

    An equity security whose price is affected by ups and downs in the overall economy. Cyclical stocks typically relate to companies ...
  3. Front Running

    The unethical practice of a broker trading an equity based on information from the analyst department before his or her clients ...
  4. After-Hours Trading - AHT

    Trading after regular trading hours on the major exchanges. The increasing popularity of electronic communication networks ...
  5. Omnibus Account

    An account between two futures merchants (brokers). It involves the transaction of individual accounts which are combined ...
  6. Weighted Average Life - WAL

    The average number of years for which each dollar of unpaid principal on a loan or mortgage remains outstanding. Once calculated, ...
Trading Center