What is the 'Prospect Theory'

Prospect theory assumes that losses and gains are valued differently, and thus individuals make decisions based on perceived gains instead of perceived losses. Also known as "loss-aversion" theory, the general concept is that if two choices are put before an individual, both equal, with one presented in terms of potential gains and the other in terms of possible losses, the former option will be chosen.

BREAKING DOWN 'Prospect Theory'

For example, consider an investor is given a pitch for the same mutual fund by two separate financial advisors. One advisor presents the fund to the investor, highlighting that it has an average return of 12% over the past three years. The other advisor tells the investor that the fund has had above-average returns in the past 10 years, but in recent years it has been declining. Prospect theory assumes that though the investor was presented with the exact same mutual fund, he is likely to buy the fund from the first advisor, who expressed the fund’s rate of return as an overall gain instead of the advisor presenting the fund as having high returns and losses.

Behind Prospect Theory

Prospect theory belongs to the behavioral economic subgroup, describing how individuals make a choice between probabilistic alternatives where risk is involved and the probability of different outcomes is unknown. This theory was formulated in 1979 and further developed in 1992 by Amos Tversky and Daniel Kahneman, deeming it more psychologically accurate of how decisions are made when compared to the expected utility theory. The underlying explanation for an individual’s behavior, under prospect theory, is that because the choices are independent and singular, the probability of a gain or a loss is reasonably assumed as being 50/50 instead of the probability that is actually presented. Essentially, the probability of a gain is generally perceived as greater.

Perceived Gains Over Perceived Losses

Tversky and Kahneman proposed that losses cause greater emotional impact on an individual than does an equivalent amount of gain, so given choices presented two ways — with both offering the same result — an individual will pick the option offering perceived gains.

For example, assume that the end result is receiving $25. One option is being given the straight $25. The other option is gaining $50 and losing $25. The utility of the $25 is exactly the same in both options. However, individuals are most likely to choose receiving the straight cash because a single gain is generally observed as more favorable than initially having more cash and then suffering a loss.

Certainty and Isolation Effects in Prospect Theory

According to Tversky and Kahneman, the certainty effect is exhibited when people prefer certain outcomes and underweight outcomes that are only probable. The certainty effect leads to individuals avoiding risk when there is a prospect of a sure gain. It also contributes to individuals seeking risk when one of their options is a sure loss. The isolation effect occurs when people are presented two options with the same outcome, but different routes to the outcome. In this case, people are likely to cancel out the similar information to lighten the cognitive load, and their conclusions will vary depending on how the options are framed. 

RELATED TERMS
  1. Biased Expectations Theory

    The biased expectations theory is a theory that the future value ...
  2. Accelerator Theory

    The accelerator theory is an economic theory whereby as demand ...
  3. Expectations Theory

    The hypothesis that long-term interest rates contain a prediction ...
  4. Social Choice Theory

    Social Choice Theory is an economic theory that considers whether ...
  5. New Growth Theory

    New growth theory is a concept that presumes the desire and wants ...
  6. Theory Of Price

    The theory of price is an economic theory whereby the price for ...
Related Articles
  1. Investing

    Seven Controversial Investing Theories

    Find out information about seven controversial investing theories that attempt to explain and influence the market as well as the actions of investors.
  2. Investing

    Redefining Investor Risk

    Changing the way you think about time and risk can change the way you invest.
  3. Trading

    Understanding Investor Behavior

    Discover how some human tendencies can play out in the market, posing the question: are we really rational?
  4. Managing Wealth

    Modern Portfolio Theory: Why It's Still Hip

    Investors still follow an old set of principles, known as modern portfolio theory (MPT), that reduce risk and increase returns through diversification.
  5. Small Business

    7 Ways Your Emotions Skew Your Business Decisions

    Important decisions such as making a key investment, increasing production or expanding into new lines are all clouded by human emotion. Can you stay cool under pressure?
  6. Insights

    Dow Theory

    Learn about the foundation upon which technical analysis is based.
RELATED FAQS
  1. 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 >>
  2. What is the chaos theory?

    The chaos theory is a complicated and disputed mathematical theory that seeks to explain the effect of seemingly insignificant ... Read Answer >>
  3. What is capital structure theory?

    Discover capital structure theory as it relates to financial management and the methods in which companies attempt to raise ... Read Answer >>
  4. How does money supply affect inflation?

    Learn about two competing economic theories of the role of the money supply and whether money supply causes inflation in ... Read Answer >>
  5. Why is game theory useful in business?

    The concepts of game theory became a revolutionary interdisciplinary phenomenon, but they are still relevant for business ... Read Answer >>
Hot Definitions
  1. Portfolio

    A portfolio is a grouping of financial assets such as stocks, bonds and cash equivalents, also their mutual, exchange-traded ...
  2. Gross Profit

    Gross profit is the profit a company makes after deducting the costs of making and selling its products, or the costs of ...
  3. Diversification

    Diversification is the strategy of investing in a variety of securities in order to lower the risk involved with putting ...
  4. Intrinsic Value

    Intrinsic value is the perceived or calculated value of a company, including tangible and intangible factors, and may differ ...
  5. Current Assets

    Current assets is a balance sheet item that represents the value of all assets that can reasonably expected to be converted ...
  6. Volatility

    Volatility measures how much the price of a security, derivative, or index fluctuates.
Trading Center