Prospect Theory

What Is the Prospect Theory?

Prospect theory assumes that losses and gains are valued differently, and thus individuals make decisions based on perceived gains instead of perceived losses. Also known as the "loss-aversion" theory, the general concept is that if two choices are put before an individual, both equal, with one presented in terms of potential gains and the other in terms of possible losses, the former option will be chosen.

How the Prospect Theory Works

Prospect theory belongs to the behavioral economic subgroup, describing how individuals make a choice between probabilistic alternatives where risk is involved and the probability of different outcomes is unknown. This theory was formulated in 1979 and further developed in 1992 by Amos Tversky and Daniel Kahneman, deeming it more psychologically accurate of how decisions are made when compared to the expected utility theory.

The underlying explanation for an individual’s behavior, under prospect theory, is that because the choices are independent and singular, the probability of a gain or a loss is reasonably assumed as being 50/50 instead of the probability that is actually presented. Essentially, the probability of a gain is generally perceived as greater.

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

For example, assume that the end result of receiving $25. One option is being given $25 outright. The other option is being given $50 and then having to give back $25. The utility of the $25 is exactly the same in both options. However, individuals are most likely to choose to receive straight cash because a single gain is generally observed as more favorable than initially having more cash and then suffering a loss.

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

Special Considerations

According to Tversky and Kahneman, the certainty effect is exhibited when people prefer certain outcomes and underweight outcomes that are only probable. The certainty effect leads to individuals avoiding risk when there is a prospect of a sure gain. It also contributes to individuals seeking risk when one of their options is a sure loss.

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

Example of Prospect Theory

Consider an investor who is given two pitches for the same mutual fund. The first advisor presents the fund to Sam, highlighting that it has an average return of 10% for the last three years. Meanwhile, a second advisor tells the investor that the fund has had above-average returns over the last decade, but has been in decline for the last three years.

Prospect theory says that although the investor has been pitched the exact same mutual fund, they are likely to buy from the first advisor. That is, the investor is more likely to buy the fund from the advisor that expresses the fund's rate of return in terms of only gains, while the second advisor presented the fund as having high returns, but also losses.

Prospect Theory FAQs 

What Does Prospect Theory Mean?

Prospect theory says that investors value gains and losses differently. That is, if an investor is presented an investment option based on potential gains, and another based on potential losses, the investor will choose an investment where potential gains are presented.

Why Is Prospect Theory Important?

It's useful for investors to understand their biases, where losses tend to cause greater emotional impact than the equivalent gain. The prospect theory helps describe hows decisions are made by investors.

What Are the Main Components of Prospect Theory?

Prospect theory is part of the behavioral economic subgroup. It describes how individuals make decisions between alternatives where risk is involved and the probability of different outcomes is unknown. There is a certainty effect exhibited in the prospect theory, where people seek certain outcomes, underweighting only probable outcomes.

Who Proposed Prospect Theory?

Prospect theory was first introduced in 1979 by Amos Tversky and Daniel Kahneman, who later developed the idea in 1992. The pair said that the prospect theory was better at accurately describing how decisions are made, compared to the expected utility theory.

What Did Kahneman and Tversky Do?

Kahneman and Tversky proposed that losses have a greater emotional impact than a gain of the same amount. They said that, given choices presented two ways — with both offering the same result — an individual will pick the option offering perceived gains.

Bottom Line

Prospect theory says that individuals will accept an investment when the gains are presented, versus the losses. That is, investors weigh potential gains more than potential losses.