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Prospect theory was developed by Daniel Kahneman and Amos Tversky in 1979 as a psychologically realistic alternative to expected utility theory. It allows one to describe how people make choices in situations where they have to decide between alternatives that involve risk, e.g. in financial decisions. Starting from empirical evidence, the theory describes how individuals evaluate potential losses and gains. In the original formulation the term prospect referred to a lottery. Daniel Kahneman Daniel Kahneman (born March 5, 1934 in Tel Aviv, in the then British Mandate of Palestine, now in Israel), is a key pioneer and theorist of behavioral finance, which integrates economics and cognitive science to explain seemingly irrational risk management behavior in human beings. ...
Amos Tversky (March 16, 1937 - June 2, 1996) was a pioneer of cognitive science, a longtime collaborator of Daniel Kahneman, and a key figure in the discovery of systematic human cognitive bias and handling of risk. ...
Also: 1979 by Smashing Pumpkins. ...
It has been suggested that Neumann-Morgenstern utility be merged into this article or section. ...
A central concept in science and the scientific method is that all evidence must be empirical, or empirically based, that is, dependent on evidence or consequences that are observable by the senses. ...
In finance, gain is a profit or an increase in value of an investment such as a stock or bond. ...
A lottery is a popular form of gambling which involves the drawing of lots for a prize. ...
The theory describes such decision processes as consisting of two stages, editing and evaluation. In the first, possible outcomes of the decision are ordered following some heuristic. In particular, people decide which outcomes they see as basically identical and they set a reference point and consider lower outcomes as losses and larger as gains. In the following evaluation phase, people behave as if they would compute a value (utility), based on the potential outcomes and their respective probabilities, and then choose the alternative having a higher utility. Image File history File links Valuefun. ...
Look up Heuristic in Wiktionary, the free dictionary. ...
In economics, utility is a measure of the relative happiness or satisfaction (gratification) gained. ...
The formula that Kahneman and Tversky assume for the evaluation phase is (in its simplest form) given by where are the potential outcomes and their respective probabilities. v is a so-called value function that assigns a value to an outcome. The value function (sketched in the Figure) which passes through the reference point is s-shaped and, as its asymmetry implies, given the same variation in absolute value, there is a bigger impact of losses than of gains (loss aversion). In contrast to Expected Utility Theory, it measures losses and gains, but not absolute wealth. The function w is called a probability weighting function and expresses that people tend to overreact to small probability events, but underreact to medium and large probabilities. In prospect theory, loss aversion. ...
To see how Prospect Theory (PT) can be applied in an example, consider a decision about buying an insurance policy. Let us assume the probability of the insured risk is 1%, the potential loss is $1000 and the premium is $15. If we apply PT, we first need to set a reference point. This could be, e.g., the current wealth, or the worst case (losing $1000). If we set the frame to the current wealth, the decision would be to either pay $15 for sure (which gives the PT-utility of v( − 15)) or a lottery with outcomes $0 (probability 99%) or $-1000 (probability 1%) which yields the PT-utility of . These expressions can be computed numerically. For typical value and weighting functions, the former expression could be larger due to the convexity of v in losses, and hence the insurance looks unattractive. If we set the frame to $-1000, both alternatives are set in gains. The concavity of the value function in gains can then lead to a preference for buying the insurance.
We see in this example that a strong overweighting of small probabilities can also undo the effect of the convexity of v in losses: the potential outcome of losing $1000 is overweighted.
The interplay of overweighting of small probabilities and concavity-convexity of the value function leads to the so-called four-fold pattern of risk attitudes: risk-averse behavior in gains involving moderate probabilities and of small probability losses; risk-seeking behavior in losses involving moderate probabilities and of small probability gains. This is an explanation for the fact that people, e.g., simultaneously buy lottery tickets and insurances, but still invest money conservatively.
Some behaviors observed in economics, like the disposition effect or the reversing of risk aversion/risk seeking in case of gains or losses (termed the reflection effect), can also be explained referring to the prospect theory. Face-to-face trading interactions on the New York Stock Exchange trading floor. ...
The Disposition Effect is an anomaly discovered in Behavioral Finance. ...
Risk aversion is a concept in economics and finance theory explaining the behaviour of consumers and investors under uncertainty. ...
This article is about the concept of risk. ...
An important implication of prospect theory is, that the way economic agents subjectively frame an outcome or transaction in their mind, affects the utility they expect or receive. This aspect has been widely used in behavioral economics and mental accounting. Framing and prospect theory has been applied to a diverse range of situations which appear inconsistent with standard economic rationality; the equity premium puzzle, the status quo bias, various gambling and betting puzzles, intertemporal consumption and the endowment effect. In economics, framing means the manner in which a rational choice problem has been presented. ...
Nobel Prize in Economics winner Daniel Kahneman, was an important figure in the development of behavioral finance and economics and continues to write extensively in the field. ...
A concept first named by Richard Thaler (1980), mental accounting attempts to describe the process whereby people code, categorise and evaluate economic outcomes. ...
The equity premium puzzle is a term coined by economists Rajnish Mehra and Edward C. Prescott in 1985. ...
Status quo bias is cognitive bias for the status quo; in other words, people like things to stay relatively the same. ...
The endowment effect is a hypothesis that people value a good (object) more once their property right to it has been established. ...
Another possible implication for economics is that utility might be reference based, in contrast with additive utility functions underlying much of neo-classical economics. This means people consider not only the value they receive, but also the value received by others. This hypothesis is consistent with psychological research into happiness, which finds subjective measures of wellbeing are relatively stable over time, even in the face of large increases in the standard of living (Easterlin, 1974; Frank, 1997). In economics, utility is a measure of the relative happiness or satisfaction (gratification) gained. ...
Neoclassical economics is the grouping of a number of schools of thought in economics. ...
Psychology (ancient Greek: psyche = soul and logos = word) is the study of mind, thought, and behaviour. ...
“Happy†redirects here. ...
The original version of prospect theory gave rise to violations of first-order stochastic dominance. That is, one prospect might be preferred to another even if it yielded a worse outcome with probability one. The editing phase overcame this problem, but at the cost of introducing intransitivity in preferences. A revised version, called cumulative prospect theory overcame this problem by using a probability weighting function derived from Rank-dependent expected utility theory. Cumulative prospect theory can also be used for infinitely many or even continuous outcomes (e.g. if the outcome can be any real number). The term Stochastic dominance is used in decision theory to refer to situations where one lottery (a probability distribution over outcomes) can be ranked as superior to another, with only limited knowledge of preferences. ...
Intransitivity is a scenario in which weighing several options produces a loop of preference. ...
Cumulative Prospect Theory is a model for descriptive decisions under risk which has been introduced by Amos Tversky and Daniel Kahneman in 1992 (Tversky, Kahneman, 1992). ...
The rank-dependent expected utility model (originally called anticipated utility) is a generalized expected utility model of choice under uncertainty, designed to explain the behaviour observed in the Allais paradox, as well as for the observation that many people both purchase lottery tickets (implying risk-loving preferences) and insure against...
In mathematics, the real numbers may be described informally as numbers that can be given by an infinite decimal representation, such as 2. ...
Sources - Easterlin, Richard A. (1974) "Does Economic Growth Improve the Human Lot?" in Paul A. David and Melvin W. Reder, eds., Nations and Households in Economic Growth: Essays in Honor of Moses Abramovitz, New York: Academic Press, Inc.
- Frank, Robert H. (1997) "The Frame of Reference as a Public Good", The Economic Journal 107 (November), 1832-1847.
- Kahneman, Daniel, and Amos Tversky (1979) "Prospect Theory: An Analysis of Decision under Risk", Econometrica, XLVII (1979), 263-291.
- Post, Thierry, Van den Assem, Martijn J., Baltussen, Guido and Thaler, Richard H., "Deal or No Deal? Decision Making Under Risk in a Large-Payoff Game Show" (April 2006). EFA 2006 Zurich Meetings Paper Available at SSRN: http://www.ssrn.com/abstract=636508
- http://prospect-theory.behaviouralfinance.net/
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