A theory, developed by the economists Daniel Kahneman and Amos Tversky, that seeks to explain how individuals make decisions when faced with uncertainty. It is central to the growing new area of research known as behavioural finance, which posits that psychology plays a major part in financial decision making. In essence, prospect theory has three components, which concern the role played by decision frames, mistakes in relation to evaluating probabilities, and a risk preference structure. To help them make a decision individuals use a framework, which has a strong influence on the decision made. Individuals believe that improbable events are more likely to occur than they are in practice, and conversely that probable events are less likely to occur than they are in practice. Moreover, they define outcomes in terms of gains and losses, with the latter having a more important impact on their welfare than the former. See also utility theory.
Subjects: Psychology — Financial Institutions and Services.