What is Prospect Theory?

By Rithika Revur2 min read · Posted Apr 22, 2023

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Have you ever wanted to take a risk on a large sum of money, like going for the lottery or gambling at a casino? If so, you are making financial choices without getting all the facts, or in other words, prospect theory. This article will detail what the prospect theory is and how it affects people in their daily lives.

What is Prospect Theory

Prospect theory is a behavioral economics theory that describes how people make decisions under uncertainty. It is based on the premise that individuals are not rational in their decision-making process and that their choices are influenced by the perceived potential gains and losses.

Prospect theory posits that individuals place greater weight on potential losses than on potential gains, which can lead to risk aversion. People are more likely to take a risk if the potential gain is significant enough to outweigh the perceived loss. The theory also suggests that individuals experience diminishing sensitivity to changes in wealth, meaning that the perceived value of a given gain or loss decreases as wealth increases.

One of the key contributions of prospect theory is the introduction of the "reference point." The reference point is the starting point from which an individual evaluates potential gains or losses. This can be influenced by a variety of factors, including past experiences and social norms.

Prospect theory has been used to explain a variety of phenomena, including why people are more likely to buy insurance when faced with a potential loss, and why investors often hold onto losing investments in the hope of recouping their losses.

Takeaways

Prospect theory is a fascinating phenomenon where people make big or small financial decisions without taking into account all the possible factors. Understanding what it is will help you make better financial decisions and be more aware when spending.

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