Prospect Theory

Prospect Theory models how a person might make a decision given the probabilities of outcomes and possible value of the outcomes. We all have a tendency to assign probabilities to possible events. Maybe we don’t do it consciously. But at least in the form of gut feeling. Probability weighting is the tendency to assign extreme events with higher probabilities. We behave differently to potential gain and loss. The reaction in fact is asymmetric depending on whether you are risk-seeing or risk-averse. This is dependent on the internal reference we use as well. Given a certain reference point, an outcome might seem more/less risky. This contradicts with expected utility theory which models the decision making of a rational individual. Our behaviour is not solely based on the value of the outcome but instead the perceived value.

Another effect in economics that can be explained by Prospect Theory is the Disposition effect. Deep down we feel good when we win and bad when we lose. If a stock that we have invested in goes down, our decision making gets affected by fear, pride and impending loss. A “rational” investor would sell the assets in order to cut the losses. However, it could be at the cost of long term gain. There is an even greater likelihood that we won’t sell an asset that has gone up, well, because it has gone up.