Prospect Theory

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What is perspective theory?

Prospect theory assumes that losses and gains are valued differently, and therefore individuals make decisions based on perceived gains rather than perceived losses. Also known as “loss aversion” theory, the general concept is that if two choices are offered to an individual, both equal, one presented in terms of potential gains and the other in terms of possible losses, the first option will be chosen.

How perspective theory works

Perspective theory belongs to the behavioral economic subgroup, describing how individuals choose between probabilistic alternatives where risk is involved and the probability of different outcomes is unknown. This theory was formulated in 1979 and developed in 1992 by Amos Tversky and Daniel Kahneman, deeming it more psychologically precise in the way decisions are made in relation to the theory of expected utility.

The underlying explanation for an individual’s behavior, according to perspective theory, is that because the choices are independent and singular, the probability of gain or loss is reasonably assumed to be 50/50 instead of the probability that is actually presented. Essentially, the probability of winning is generally perceived to be higher.

Key points to remember

Although there is no difference in the actual gains or losses of a certain product, prospect theory says that investors will choose the product that offers the most perceived gains.

Tversky and Kahneman proposed that losses cause a greater emotional impact on an individual than an equivalent amount of gain, therefore, given the choices presented in two ways – with both offering the same result – an individual will choose the option offering perceived gains.

For example, suppose the final result receives $ 25. An option is given the $ 25 fee. The other option wins $ 50 and loses $ 25. The usefulness of the $ 25 is exactly the same in both options. However, individuals are more likely to choose to receive cash, since a one-time gain is generally considered to be more favorable than having more money initially and then incurring a loss.

Types of perspective theory

According to Tversky and Kahneman, the effect of certainty manifests itself when people prefer certain results and underweight results that are only likely. The effect of certainty leads individuals to avoid risks when there is a prospect of certain gain. It also contributes to individuals looking for risk when one of their options is a certain loss.

The isolation effect occurs when people have presented two options with the same result, but different paths to the result. In this case, people are likely to cancel similar information to lighten the cognitive load, and their conclusions vary depending on how the options are formulated.

Key points to remember

  • Perspective theory says that investors assess gains and losses differently, giving more weight to perceived gains than to perceived losses.
  • An investor with a choice, both equal, will choose the one presented in terms of potential gains.
  • Outlook theory is part of behavioral economics, suggesting that investors have chosen perceived gains because losses have a greater emotional impact.
  • The certainty effect indicates that individuals prefer certain results to the probable, while the isolation effect indicates that individuals cancel similar information when they make a decision.

Example of perspective theory

Imagine that an investor is assigned the same mutual fund by two separate financial advisers. An advisor introduced the fund to the investor, noting that it has had an average return of 12% over the past three years. The other advisor tells the investor that the fund has outperformed the fund over the past 10 years, but has declined over the past few years. Prospect theory assumes that even if the investor received the exact same mutual fund, he is likely to buy the fund from the first adviser, who expressed the fund’s rate of return as an overall gain instead of the advisor only portrays the fund as having high returns. and losses.

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