Behavioral finance V. Prospect theory
Prospect theory
The most cited article ever published in the prestigious academic journal Econometrica was written by two psychologists, Kahneman and Tversky, in 1979 and is titled "Prospect Theory: An Analysis of Decision under Risk." They presented a critique of expected utility theory as a descriptive model for decision-making under risk and developed an alternative model called prospect theory. Through empirical observation, Kahneman and Tversky discovered that people tend to undervalue outcomes that are less probable compared to outcomes that occur with certainty. Additionally, people generally disregard the complementary elements of all options they are considering.
In prospect theory, value is assigned to gains and losses rather than total wealth, and probabilities are replaced with decision weights. The value function is defined by deviations from a reference point and is typically concave for gains—indicating risk aversion—and convex for losses—due to risk-seeking behavior. In general, the function is steeper for losses than for gains, reflecting loss aversion. The shape of the value function is illustrated on image 1 above. Decision weights are generally lower than the actual probabilities, except in the case of low probabilities, as shown on image 2 below.
Montier (2002) describes prospect theory as follows:
"Prospect theory has probably done more than any other theory to bring psychology into the heart of economic analysis. Many economists still rely on the expected utility paradigm when addressing problems, but prospect theory has gained much more traction in recent years. It clearly holds second place among the research efforts of mainstream economists today. Beyond psychology, prospect theory also has a solid mathematical foundation, making it both convenient and appealing for economists to engage with. The essential difference between expected utility theory and prospect theory is that expected utility theory focuses on how decisions under uncertainty should be made (a normative approach), while prospect theory focuses on how decisions are actually made (a descriptive approach). Kahneman and Tversky developed this theory to define numerous violations and deviations from classical rationality they uncovered in their empirical work. Prospect theory offers more than just an alternative to expected utility theory."
Cornell (1999) provides a concise definition relevant to finance and investing:
"In short, prospect theory assumes that investors' utility functions depend more on changes in the value of their portfolios than on the overall level of wealth. In other words, utility is based on returns rather than asset value."
Barberis and Thaler (2003) highlight prospect theory as the most promising for financial applications among theories challenging expected utility theory. Its strength lies in the most successful experimental results, which is hardly surprising. Most opposing theories to expected utility can be called quasi-normative, meaning they try to capture some type of anomaly based on experimental evidence by slightly relaxing the Von Neumann-Morgenstern axioms. The complexity of these models and theories stems from their attempt to achieve two goals—normative and descriptive. Ultimately, they are unsatisfactory for either purpose. In contrast, prospect theory has no interest in being normative. It aims to capture human attitudes toward risk and uncertainty as accurately as possible. Tversky and Kahneman compellingly demonstrate that normative approaches are doomed to fail because people often make decisions that violate dominance or the invariance of theoretical knowledge.
Prospect theory remains a solid foundation and starting point for many alternative behavioral finance theories or forms part of them. For any expert in financial theory or practice, prospect theory represents one of the main pillars, or for some, even the cornerstone of behavioral finance.