Prospect Theory explains how people make decisions under risk, emphasizing that individuals value potential losses more than equivalent gains. For example, losing ₹100 feels worse than gaining ₹100. Key features include loss aversion, reference dependence and weighting probabilities rather than following the expected utility theory.
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What Is Prospect Theory?
Prospect Theory, developed by Daniel Kahneman and Amos Tversky, describes how individuals make decisions under risk by valuing potential losses more than equivalent gains. It challenges traditional utility theory by introducing loss aversion, reference dependence and probability distortion as key behavioural decision-making factors.
Prospect Theory reveals that people evaluate outcomes relative to a reference point, rather than absolute wealth. This creates asymmetric value perceptions, where losses loom larger than gains. The theory emphasizes psychological factors influencing decisions, highlighting why individuals may act irrationally under risky circumstances.
It also introduces probability weighting, where people overestimate low-probability events and underestimate high-probability ones. This deviation from rational utility-based decisions explains common behaviours, such as buying insurance or lottery tickets, driven by subjective perceptions of risk and reward.
Example Of Prospect Theory
Consider an individual given two choices: a guaranteed ₹500 or a 50% chance to win ₹1,000. Prospect Theory predicts they’d likely choose ₹500 due to loss aversion, favouring certainty over potential risk.
Similarly, if the same individual faces a guaranteed loss of ₹500 versus a 50% chance to lose ₹1,000, they might gamble to avoid the certain loss. This highlights the asymmetry in risk behaviour for gains versus losses, where people become risk-seeking to avoid losses.
The example demonstrates how reference points and loss aversion shape preferences. Gains are valued less intensely than equivalent losses, driving choices that deviate from the expected utility model in risk-laden situations.
How Prospect Theory Works?
Prospect Theory works by explaining decision-making under risk through three key concepts: loss aversion, where losses hurt more than gains; reference dependence, where outcomes are relative; and probability distortion, altering perceived likelihoods of events.
These concepts suggest that people avoid risks when considering potential gains but take risks to avoid losses. This explains inconsistent behaviours like over-insuring against rare events or betting aggressively to recover losses, deviating from rational utility optimization.
Probability weighting distorts actual odds, leading to overvaluation of unlikely outcomes, such as winning a lottery. This psychological framework uncovers how emotions and cognitive biases influence financial and life decisions beyond traditional economic models.
History of Prospect Theory
Developed by psychologists Daniel Kahneman and Amos Tversky in 1979, Prospect Theory revolutionized behavioural economics by challenging expected utility theory. Their experiments revealed systematic biases in decision-making under uncertainty, forming the foundation of modern behavioural finance.
Their work showed that people evaluate outcomes relative to a reference point, not absolute wealth. Loss aversion and probability distortion emerged as central insights, explaining real-world behaviours like risk-seeking to avoid losses and risk aversion in gains.
Prospect Theory earned Daniel Kahneman the Nobel Prize in Economics in 2002. Its influence extends across disciplines, reshaping understanding of human behaviour in economics, finance and psychology, providing tools for analyzing irrational decision-making.
Features of Prospect Theory
The main features of Prospect Theory include loss aversion, where losses are valued more intensely than gains; reference dependence, where decisions are based on relative outcomes; and probability distortion, where people misjudge the likelihood of rare and common events, influencing risk preferences.
- Loss Aversion: People perceive losses as more significant than equivalent gains. For instance, losing ₹100 feels worse than gaining ₹100, leading to risk-averse behaviour in gains and risk-seeking behaviour in losses.
- Reference Dependence: Decisions are influenced by a reference point, such as current wealth or expectations. Gains and losses are evaluated relative to this baseline rather than absolute values, shaping decision outcomes.
- Probability Distortion: Individuals overestimate low-probability events, like lottery wins and underestimate high-probability events, like accidents. This misjudgment alters risk perception, explaining behaviours like excessive gambling or over-insurance for unlikely risks.
- Diminishing Sensitivity: People value incremental changes less as the magnitude increases. For example, gaining ₹100 is more satisfying when you have ₹0 than when you already have ₹10,000, affecting the perceived utility of outcomes.
Advantages Of Prospect Theory
The main advantage of Prospect Theory is its realistic portrayal of human decision-making under risk, accounting for emotions and cognitive biases. It explains behaviours like loss aversion and probability distortion, offering valuable insights for behavioural economics, financial planning and policymaking.
- Realistic Decision-Making Model: Prospect Theory reflects actual human behaviour under risk, considering psychological factors like emotions and biases, making it more applicable than traditional models like expected utility theory.
- Explains Loss Aversion: It highlights how losses are valued more than gains, helping to understand risk-averse or risk-seeking behaviours in financial decisions, insurance purchases and everyday choices.
- Probability Weighting Insights: The theory explains why people overestimate rare events, such as lottery wins and underestimate common ones, providing a better understanding of gambling, insurance and investment behaviours.
- Practical Applications: It is widely used in behavioural economics, marketing and public policy to design strategies that align with real-world decision-making, influencing consumer behaviour and financial planning effectively.
Limitations Of Prospect Theory
The main limitation of Prospect Theory is its reliance on subjective reference points, which vary between individuals, making predictions inconsistent. Additionally, it focuses on descriptive analysis rather than providing clear solutions, limiting its applicability in complex, real-world decision-making scenarios.
- Subjective Reference Points: Prospect Theory relies on reference points, which differ across individuals, making predictions inconsistent and challenging to generalize for diverse populations or situations.
- Focus on Description: The theory describes decision-making but lacks prescriptive solutions, limiting its utility for providing actionable guidance in complex scenarios like financial planning or policymaking.
- Limited Real-World Application: It assumes static conditions and simplified choices, which don’t always align with dynamic, multi-faceted real-world decisions, reducing its practical effectiveness in varied contexts.
- Neglect of Long-Term Effects: Prospect Theory focuses on short-term decision-making and doesn’t adequately address how individuals evaluate long-term consequences, limiting its relevance for strategic or forward-looking planning.
Prospect Theory Meaning – Quick Summary
- Prospect Theory explains how people make decisions under risk, emphasizing loss aversion, reference dependence and probability distortion, challenging traditional utility theory. It highlights psychological factors influencing choices in uncertain situations.
- An individual prefers a guaranteed ₹500 over a 50% chance to win ₹1,000 due to loss aversion. Similarly, they may gamble to avoid losses, showing asymmetry in risk behaviour for gains and losses.
- Prospect Theory explains decision-making through loss aversion, reference dependence and probability distortion. It shows why people avoid risks with gains but take risks to prevent losses, revealing biases in risk perception.
- Developed by Kahneman and Tversky in 1979, Prospect Theory challenged utility theory by revealing decision-making biases. It influenced behavioural economics, earning Kahneman a Nobel Prize and reshaping understanding of human behaviour.
- The main features of Prospect Theory include loss aversion, where losses are more painful than gains; reference dependence, where decisions rely on relative outcomes; and probability distortion, where people misjudge rare and common event likelihoods.
- The main advantage of Prospect Theory is its realistic portrayal of decision-making under risk, accounting for emotions and biases. It provides valuable insights for behavioural economics, financial planning and policymaking, explaining irrational human behaviours.
- The main limitation of Prospect Theory is its reliance on subjective reference points, leading to inconsistent predictions. It focuses on descriptive analysis without offering prescriptive solutions, limiting its use in complex, real-world decision-making.
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Prospect Theory – FAQs
Prospect Theory explains decision-making under risk, showing how individuals value potential losses more than equivalent gains. It introduces concepts like loss aversion, reference dependence and probability distortion, challenging traditional utility theory’s assumptions about rational behaviour.
The main features of Prospect Theory include loss aversion, where losses outweigh gains in perceived value; reference dependence, where decisions are based on relative outcomes; and probability distortion, where people misjudge rare and common events’ likelihoods, influencing risk preferences.
Prospect Theory doesn’t have a single fixed formula. However, it uses a value function to quantify losses and gains relative to a reference point and a probability weighting function to adjust perceived probabilities, explaining decision-making biases under risk.
Prospect Theory highlights the impact of framing and loss aversion in negotiations. Presenting proposals as avoiding losses rather than achieving gains can influence decision-making, encourage concessions and align strategies with psychological preferences for perceived certainty.
Daniel Kahneman and Amos Tversky developed Prospect Theory in 1979, revolutionizing behavioural economics. Their work revealed systematic biases in decision-making under uncertainty, earning Kahneman the Nobel Prize in Economics for its profound impact on economic and psychological research.
Criticisms of Prospect Theory include its reliance on subjective reference points, which vary across individuals, limiting predictive accuracy. It emphasizes descriptive insights without offering prescriptive solutions, reducing its practical applicability in complex real-world decision-making scenarios.
Prospect Theory differs by emphasizing loss aversion, reference dependence and probability distortion, whereas Expected Utility Theory assumes rational decisions based solely on utility maximization. Prospect Theory better explains behavioural biases in real-world risk-laden decision-making.
The main components of Prospect Theory are the value function, which measures gains and losses relative to a reference point and the probability weighting function, which adjusts perceived probabilities, explaining deviations from rational utility-based decision-making under risk.
Loss aversion is central to Prospect Theory, explaining why losses are perceived as more significant than equivalent gains. This asymmetry shapes risk preferences, leading to risk-averse behaviour for gains and risk-seeking behaviour to avoid losses.
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