Describe Prospect Theory very briefly

The answer of the following question is given below in a detailed manner as follows :

The prospect theory assumes that gains and losses are valued differently, and thus individuals make decisions based on perceived gains rather than perceived losses. Also known as the "loss aversion" theory, the general concept is that if an individual is presented with two options, both equal, one presented in terms of potential gains and the other in terms of possible losses, the first option will be chosen.

Perspective theory belongs to the behavioral economics subgroup and describes how individuals choose between probabilistic alternatives in which there is risk and the probability of different outcomes is unknown. This theory was formulated in 1979 and developed in 1992 by Amos Tversky and Daniel Kahneman, considering it more psychologically accurate on how decisions are made 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 an equivalent amount of gain, so given the options presented in two ways, both offer the same result, an individual will choose the option that offers perceived gains.

For example, suppose the end result receives $ 25. One option is to receive the $ 25. The other option is to win $ 50 and lose $ 25. The profit of the $ 25 is exactly the same in both options. However, people are more likely to choose to receive cash, because a single gain is generally considered more favorable than initially having more cash and then suffering a loss.

Types of prospect theory

According to Tversky and Kahneman, the certainty effect is exhibited when people prefer certain results and underweight results that are only likely. The certainty effect leads people to avoid risk when there is the possibility of a sure gain. It also helps people seek risk when one of their options is a certain loss.

So for better understanding let's discuss one more example as follows

Consider two independent financial advisers giving an investor a speech for the same mutual fund. An advisor presents the fund to the investor and highlights that it has an average return of 12% over the last three years. The other advisor tells the investor that the fund has had above-average returns in the last 10 years, but has been declining in recent years. The prospectus theory assumes that even though the investor was presented with the exact same mutual fund, they are likely to buy the fund from the first advisor, who expressed the fund's rate of return as an overall profit rather than the advisor presenting the fund as high performance. and losses.