872018 Whats Prospect Theory? Definition and Meaning MBN MBN HEALTH Business Technology —_Financial Glossary Q What is prospect theory? Definition and meaning The definition and meaning of prospect theory, also known as /oss-aversion theory, holds that as humans dislike losses more than equivalent gains, we are more willing to take risks in order to avoid a loss than to take a risk in order to obtain an equivalent gain. Its a behavioral model that shows how we decide between alternatives that involve uncertainty and risk ~ such as the percentage likelihood of gains or losses. The theory, one of the theories of behavioral economics, based on experimental work of Daniel Kahneman, an Israeli-American psychologist who was awarded the 2002 Nobel Memorial Prize in Economic Sciences, and Amos Tversky (1937-1996), an Israeli-American cognitive and mathematical psychologist, holds that there are recurring biases that influence our choices under uncertainty — driven by psychological factors. Kahneman and Tversky's study — Loss-Aversion Theory: An Analysis of Decision under Risk — was published by the journal Econometrica in March 1979. According to prospect theory, humans process information illogically by valuing gains and losses differently hitps:marketbusinessrews.comiinancial-lossarylprospect-theory-defniton-mearing! 18872018 Whats Prospect Theory? Definition and Meaning Prospect Theory [ Given $200 | Given $100 $100 Stolen xe rc ‘Not so nice memory!’ Why is second memory not so nice if in both cases she is $100 better off? The second memory is not so nice because, according to loss-aversion theory, we give an unpleasant event more negative weight than the equivalent positive weight for a positive event. Losing $100 has more negative weight than the positive weight we get from receiving $100. This irrational or illogical way of thinking is what Kahneman and Tversky observed. In an Abstract preceding their paper, Kahneman and Tversky wrote: “Choices among risky prospects exhibit several pervasive effects that are inconsistent with the basic tenets of utility theory.” “In particular, people underweight outcomes that are merely probable in comparison with outcomes that are obtained with certainty. This tendency, called the certainty effect, contributes to risk aversion in choices involving sure gains and to risk seeking in choices involving sure losses.” hitps:marketbusinessrews.comiinancial-lossarylprospect-theory-defniton-mearing! 28872018 Whats Prospect Theory? Definition and Meaning “In addition, people generally discard components that are shared by all prospects under consideration. This tendency, called the isolation effect, leads to inconsistent preferences when the same choice is presented in different forms.” Prospect theory and irrational behavior Prospect theory is very useful for explaining people's apparent irrational behavior. Kahneman and Tversky found that losses had more emotional impact than the equivalent amount of gain for people. For example, in a traditional way of thinking, we should gain the same amount of utility (pleasure, satisfaction) if we received $100, or first received $200 and then lost $100, because the end result would be the same ~ a $100 net gain. Prospect Theory Gets 9% raise Get no raise hitps:marketbusinessrews.comiinancial-lossarylprospect-theory-defniton-mearing! ae