Prospect Theory Definition
Prospect theory
Young Joon Suh
Definition
Prospect theory is a theory of decision making that involves risk and uncertainty. It is an economic theory with psychological elements that aims to explain how people decide between alternatives with probabilistic gains and losses. The theory is based on the premise that people make choices based upon their psychological value of potential losses and gains rather than the final outcome. Prospect theory explains why people make decisions that deviate from rational decision making by examining how the expected outcomes of alternative choices are perceived (Kahneman & Tversky, 1979).
Historical background
Until 1970s, the dominant theory for decision making research was Expected utility theory (Barberis,
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The research in the finance area applies Prospect theory in the cross section of average returns, the aggregate stock market, and the trading of financial assets over time. Insurance is another area of economics where attitudes to risk play a central role. As such, it too is a promising place to look for applications of Prospect theory. For example, Sydnor (2010) studies the insurance decisions of 50,000 customers of a large home insurance company. The main decision that these households have to make is to choose a deductible from a menu of four possibilities: $100, $250, $500, and $1,000. Sydnor (2010) finds that due to householder’s extra focus on the unlikely but unpleasant outcome, the householder is willing to pay a higher premium for a policy with a lower deductible. Sydnor (2010) suggests that an approach based on the probability weighting component of Prospect theory would explain the decision making of householders. Under probability weighting, a household overweighs the state in which a claim occurs and it has to pay the deductible. Sydnor (2010) also notes that the householder’s reference point might explain the high premium the householder chooses to pay as predicted by Prospect
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