Prospect Theory: What It Is and How It Works, With Examples

Prospect theory is a behavioral economics theory that describes how people make decisions under uncertainty. It was developed by Daniel Kahneman and Amos Tversky in the 1970s.

Prospect theory is based on the idea that people are not rational decision-makers. Instead, they are influenced by their emotions and biases. This means that people's decisions are not always based on the facts, but on how they feel about the situation.

Prospect theory has two main components:

* **The value function:** This function describes how people value gains and losses. People are more sensitive to losses than they are to gains. This is known as loss aversion.
* **The decision frame:** This describes the way people frame a decision. People are more likely to take risks when they are presented with a positive frame, and less likely to take risks when they are presented with a negative frame.

Prospect theory has been used to explain a wide range of financial decisions, including:

* **Investment decisions:** People are more likely to invest in risky assets when they are feeling optimistic, and less likely to invest in risky assets when they are feeling pessimistic.
* **Saving decisions:** People are more likely to save for the future when they are presented with a positive frame, and less likely to save for the future when they are presented with a negative frame.
* **Risky choices:** People are more likely to take risks when they are presented with a small probability of a large gain, and less likely to take risks when they are presented with a large probability of a small gain.

Prospect theory is a powerful tool for understanding how people make financial decisions. It can help investors and financial advisors make better decisions by understanding the biases that influence people's decisions.

Here are some examples of how prospect theory can be used to explain financial decisions:

* **Investment decisions:** People are more likely to invest in risky assets when they are feeling optimistic. This is because they are more likely to focus on the potential gains, and less likely to focus on the potential losses.
* **Saving decisions:** People are more likely to save for the future when they are presented with a positive frame. This is because they are more likely to focus on the benefits of saving, and less likely to focus on the costs of saving.
* **Risky choices:** People are more likely to take risks when they are presented with a small probability of a large gain. This is because they are more likely to focus on the potential gains, and less likely to focus on the potential losses.

Prospect theory is a complex theory, but it can be a powerful tool for understanding how people make financial decisions. By understanding the biases that influence people's decisions, investors and financial advisors can make better decisions.