Prospect Theory
AdvancedProspect theory is a theory of how people make decisions involving risk, showing that they judge outcomes as gains or losses relative to a reference point and feel losses more strongly than equivalent gains.
Prospect theory was developed by psychologists Daniel Kahneman and Amos Tversky in 1979, and Kahneman received the Nobel Prize in Economics in 2002 partly for this work. It challenged the traditional view that people make rational choices to maximise their total wealth.
The theory has several key ideas. People evaluate outcomes as changes from a reference point, such as the price paid for a share, rather than as final wealth. Losses hurt more than gains of the same size feel good, often roughly twice as much. People tend to be cautious when facing gains but willing to take risks to avoid losses. And they overweight small probabilities, which helps explain the appeal of lottery tickets and insurance.
For example, many people prefer a certain gain of 500 over a 50% chance of 1,000, but prefer a 50% chance of losing 1,000 over a certain loss of 500.
Prospect theory is a cornerstone of behavioral finance. It helps explain the disposition effect, demand for insurance and many patterns in markets.
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