Understanding Prospect

Theory
Prospect Theory, crafted by Nobel laureates Daniel Kahneman and Amos
Tversky, explains decision-making under uncertainty by individuals, and has
been a major contribution to behavioral finance. Kahneman and Tversky were
awarded the Nobel Prize in Economic Sciences in 2002 for their
groundbreaking work in this field.

by Asha Sood & Tanisha Navetia

Application of Prospect Theory
in Investments
A case in point for implementation of Prospect Theory in investment decision-
making revolves around imagining the choice between investing in Stock A
with a potential gain of $1,000 versus Stock B, with a chance of potential loss of
$1,000. Individuals tend to exhibit risk aversion when weighing potential gains,
thus favoring the guaranteed gain of Stock A. However, the chance for potential
losses in Stock B inclines them toward risk-seeking.
Application of Prospect Theory in
Consumer Behavior
Another prospect theory manifestation is evident in consumer choices, like choosing between 2
smartphones: Smartphone X at $500 and Smartphone Y at $600, labelled "$100 off the regular price".
Upon framing these choices, it is observed that Smartphone Y gathers higher sales as it is perceived as a
$100 discount.

Smartphone X - $500 Smartphone Y - $600

Drawbacks of Prospect Theory
The reliability of Prospect Theory in generating optimal decisions is hindered by people’s unique risk
subjection and reference points. Cognitive biases like anchoring to reference points and overweighting
small probabilities further diminish the Theory’s accuracy in decision-making. Nevertheless, ongoing
research in behavioral finance aims to refine our comprehension of human choice-making.

Biases in Perception Unique Preferences Research Continues

Probabilities perception is People have a range of risk Behavioral finance experts

inconsistent and can lead preferences and reference continue to research and
to suboptimal decisions. points, making accurate improve upon our
prediction difficult. understanding of human
decision-making.
Real-World Applications Abound
Prospect Theory's fundamental breakthrough holds an expansive spectrum of real-world applications,
from medicine and law to sports and politics. Acknowledging and understanding the intricacies of
human behavior exhibiting Prospect Theory tendencies have transformative consequences regarding
policy implications and individual choices.

1 Medicine

Understanding how patients assess risks and make decisions.

2 Law

Evaluating legal systems and approach to justice.

3 Sports

Player decision-making in games of chance and strategy.

4 Politics

Voter preferences and political choice.