Prospect Theory: The Factor Deciding The Outcome of A Purchase

What Is the Prospect Theory?

Prospect theory can be said to be a theory relating to behavioral economics as well as behavioral finance that had been developed by the persons named Daniel Kahneman and Amos Tversky in the year of 1979. The theory had been cited in the specific decision to actually award Kahneman the Nobel Memorial Prize in the year of 2002 in the subject of Economics. The prospect theory actually assumes that the losses as well as the gains are actually valued very differently, and therefore, the individuals actually make the decisions on the basis of the perceived gains rather than the perceived losses. Also called to be the ‘loss-aversion’ theory, the overall idea is that if 2 specific choices are actually put before any individual, both of them equal, with 1 presented in the terms of the potential gains and the 2^nd one in the terms of the possible losses, the previous option shall be selected.

How Does the Prospect Theory work?

Prospect theory actually belongs to the specific behavioral economic subgroup, which describes the manner in which the individuals should make a choice amidst the probabilistic alternatives where the risk is tangled as well as the probability of diverse outcomes is not known. This theory had been formulated in the year of 1979 and further advanced in the year of 1992 by Amos Tversky and Daniel Kahneman, estimating it to be more psychologically precise of the manner in which the decisions are actually made in comparison to the anticipated utility theory.

The fundamental explanation in connection to the behavior of an individual, under the prospect theory, is that due to the fact that the choices are autonomous and particular, the likelihood of any gain or any loss is rationally assumed as being 50-50 rather than the likelihood that is actually offered. Fundamentally, the likelihood of any gain is usually professed as greater.

It had been proposed by Tversky and Kahneman that the losses give rise to a greater emotional bearing on a person than does an equal amount of the gain, hence the provided choices presented 2 ways—in case of both offering a similar result—a person will select the option offering the perceived gains.

Example of Prospect Theory

Consider any particular investor who has been provided with 2 specific pitches for the same particular mutual fund. The 1^st advisor offers the fund to Sam, accentuating that it has a regular return of 10 per cent for the last 3 years. In the meantime, a 2^nd advisor says to the investor that the specific fund has had more than average returns over the course of last decade, although, it has been in the decline for the last 3 years.

In this regard, it is deliberated by the Prospect theory that even though the specific investor has been given the exact same particular mutual fund, they are expected to purchase from the very 1^st advisor. That is, the specific investor is more expected to purchase the fund from the specific advisor that actually expresses the rate of return of the fund in the terms of just gains, while the 2^nd advisor offered the fund as having high returns, but also losses.

Why Is Prospect Theory Important?

Prospect theory can be said to be a theory relating to behavioral economics as well as behavioral finance that had been developed by the person's named Daniel Kahneman and Amos Tversky in the year of 1979. The prospect theory actually assumes that the losses, as well as the gains, are actually valued very differently, and therefore, the individuals actually make the decisions on the basis of the perceived gains rather than the perceived losses. The prospect theory can be said to be very useful for the investors in order to understand the particular biases, where the losses have a tendency to cause bigger emotional impact in comparison to the equivalent gain. The particular prospect theory actually facilitates in describing the manner in which the decisions are actually made by the investors.

Particularly significant implication of the prospect theory can be said to be that the manner in which the specific economic agents instinctively frame a particular outcome or else a transaction in their own minds and how it causes an impact upon the utility that is received or expected. The digital age has actually carried the implementation of the prospect theory in the3 software. Framing as well as the prospect theory has actually been applied to a varied range of circumstances which appear erratic or varying with the particular standard economic rationality.

What Are the Main Components of Prospect Theory?

Prospect theory can be said to be a part of the particular behavioral economic subgroup. It actually forwards a description regarding the manner in which the individuals essentially make the decisions amidst the alternatives where the risk is involved and the likelihood of different outcomes is not actually known. There can be said to be a certainty effect showed in the above said prospect theory, where the people pursue certain specific outcomes, underweighting just the likely outcomes.

How does prospect theory decide outcome purchase?

The prospect theory actually assumes that the losses as well as the gains are actually valued very differently, and therefore, the individuals actually make the decisions on the basis of the perceived gains rather than the perceived losses. The prospect theory can be said to be very useful for the investors in order to understand the particular biases, where the losses have a tendency to cause bigger emotional impact in comparison to the equivalent gain. The prospect theory actually specifies that the investors value the gains as well as the losses very differently, placing a lot more weight upon the perceived gains versus the perceived losses. Any investor presented with any choice, both the equal, will select the one that is presented in the terms of the potential gains. The prospect theory can also said to be known to be the loss-aversion theory.