prospect theory

Most newbie investors often commit the mistake of copying what most successful investors do. They do not do their research and base their assumptions on what other investors do. This haphazard investment decisions often lead to losses. To continue our investment theory series, this article will discuss prospect theory. 

What Is the Prospect Theory?

Prospect theory is an investment theory popularized by Daniel Kahneman and Amos Tversky in 1979. It believes that losses and gains are respected differently, and thus the theory suggests that individuals make decisions based on professed gains instead of professed losses. They place more importance on profits rather than losses. As a result, will try to make conclusions that only takes into consideration the gains. The overall perception is that if two selections with equal value are put before an individual, they would instead go with the one that was presented to have probable gains than the one offered with conceivable losses.

How Does the Prospect Theory Work?

Prospect theory has its place in the behavioural economic subsection. It classifies how individuals choose between probabilistic replacements where risk is tangled, and the likelihood of different results is unidentified. Damian Kahneman claims that the reasoning depends on how psychologically precise the judgement is. 

Under prospect theory, the fundamental justification for an individual’s behaviour is because the choices are liberated and singular. There is a rational assumption of a 50/50 gain or loss instead of looking at the actual offering. In essence, there is an assumption of a profit. 

The prospect theory articulates that investors will decide on the product that offers the most perceived gains even if there is no difference in the actual profits or losses of a particular product.

Kahneman and Tversky believe that losses cause a more significant emotional effect on an individual than a corresponding amount of gain, so given choices presented in two ways – with both proposing the same outcome – an individual will pick the option offering perceived benefits.

Assume that the end product receives $25. One alternative is to win the straightforward $25. The other option is to gain $50 and lose $25. The value of the $25 is precisely the same in both alternatives. Nevertheless, individuals are most likely to choose to receive straight cash. A single gain is usually perceived as more advantageous than initially having more money and then anguish a loss.

What Are the Different Types of Prospect Theory?

Certainty Effect

This prospect theory type occurs when people favour definite outcomes and under weigh probable outcomes. It leads to individuals evading risk when there is a prospect of a guaranteed gain. It can also be contributed to the individuals who are seeking risk when one of their options is an inevitable loss.

Isolation Effect

This prospect theory type, on the other hand, happens when there are two options with the same result are offered. Participants are likely to cancel out the same data to reduce the reasoning load, and their conclusions will vary depending on how the options are mounted.

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