Propect Theory behavioral finance rik averse

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1. Behavioral Finance
Prospect Theory
Instructor
Mazhar Farid

2. Agenda
•Prospect Theory (Kahneman and Tversky)
•Behavioral Heuristics and Biases in
Decision Making
•Implications for Financial Markets

3. What is Prospect Theory?
•Prospect theory is a psychology theory that
describes how people make decisions when
presented with alternatives that involve risk,
probability, anduncertainty. It holds that
people make decisions based on perceived
losses or gains.

5. •Given the choice of equal probabilities, most
people would choose to retain the wealth that they
already have, rather than risk the chance to
increase their current wealth. People are usually
averse to the possibility of losing, such that they
would rather avoid a loss rather than take a risk to
make an equivalent gain.

6. History of Prospect Theory
•The prospect theory is sometimes referred to as theloss-
aversiontheory. The theory was introduced by two
psychologists, Daniel Kahneman, and Amos Tversky, to
describe how humans make decisions when presented with
several choices.
•The theory was contained in the paper “Prospect Theory:
An Analysis of Decision under Risk” that was published in
the “Econometrica” journal in 1979. Since it was
developed, the prospect theory’s been used in various
disciplines. It is used to evaluate various aspects of
political decision-making in international relations.

7. Phases of Prospect Theory
The theory describes the decision-making process in two
phases, which include:
•1. Editing phase
•The editing phase refers to how people involved in
decision-making characterize the options for choice or the
framing effects. The effects explain how a person’s choice
is influenced by the wording, order, or method in which
the choices are presented.

8. An example to demonstrate the framing effect
can be the choices that cancer patients are
given. Usually, cancer patients are presented
with the choice of undergoing surgery or
chemotherapy to treat their illnesses, and they
make a decision based on whether the
outcome statistics are presented in terms of
survival rates or mortality rates. Once the
choices have been framed ready for decision-
making, the theory enters the second phase.

9. 2. Evaluation phase
•In the evaluation phase, people tend to
behave as if they would make a decision
based on the potential outcomes and choose
the option with a higher utility. The phase
usesstatistical analysisto measure and
compare the outcomes of each prospect.
The evaluation phase comprises two
indices, i.e., the value function and the
weighting function, which are used to
compare the prospects.

10. Features of the Prospect
Theory
•1. Certainty
•When presented with several options to choose from,
humans show a strong preference for the option with
certainty. They are willing to sacrifice the option that
offers more potential income in order to achieve more
certainty. For example, assume that a lottery provides two
options, A and B.
•Option A provides a guaranteed win of $100 while option
B provides the possibility of winning $200, with a 70%
chance of winning and 30% chance of losing. Most
people will choose option Asince it provides a guaranteed
win, even though it offers a lower return compared to B.

11. 2. Small probabilities
•Peopletendtodiscountverysmall
probabilitiess.Bydiscountingthesmall
probabilities,peopleendupchoosing
higher-riskoptionswithhigher
probabilities.

12. 3. Relative positioning
•Relativepositioningmeansthatpeopletendtofocusless
ontheirfinalincomeorwealth,andmoreontherelative
gainsorlossesthattheywillget.Iftheirrelativeposition
doesnotimprovewithincreasesinincome,theywillnot
feelbetteroff.Thismeansthatpeopletendtocompare
themselvestotheirneighbors,friends,andfamily
members,andarelessinterestedinwhethertheyarebetter
offthantheyweresomeyearsback.
•For example, if everybody in the office gets a 20% raise,
no individual will feel better off. However, if the person
gets a 10% raise, and other people fail to get a raise, that
person will feel better off and richer than everyone else.
•

13. 4. Loss aversion
•People tend to give more weight to losses
rather than gains made by taking a certain
option. For example, if a person makes
$200 in profits and $100 in losses, the
person will focus on the loss even though
they emerged with a $100 net gain. This
shows that people are more concerned about
losses rather than gains.
•

14. Criticism of Prospect Theory
•Oneofthecriticismsoftheprospectstheoryis
thatitlackspsychologicalexplanationsforthe
processittalksabout.Thecriticismcomesfrom
otherpsychologistswhonotesthatfactorssuchas
humanemotionalandaffectiveresponsesthatare
importantinthedecision-makingprocessare
absentinthemodel.
•Thetheoryisalsocriticizedfortheinadequate
framingtheorythatexplainswhyactorsgenerate
theframestheyuse.Decision-makersoftenneed
todealwithcompetingframesacrossvarious
issues.

15. Additional Resources
•CFI offers theFinancial Modeling &
Valuation Analyst (FMVA)™certification
program for those looking to take their
careers to the next level. To keep learning
and advancing your career, the following
CFI resources will be helpful:
•Investing: A Beginner’s Guide
•Moral Hazard
•Risk-Adjusted Return Ratios
•Total Probability Rule

16. Reference
•https://corporatefinanceinstitute.com/resour
ces/knowledge/other/prospect-theory/