2. Prospect Theory Flashcards
What is the main assumption that is used in the prospect theory ?
People evaluate outcomes according to the Expected Utility Theory (maximize your outcome).
What is the shape of the utility function depending on if the person is risk averse, neutral or seeking.
Averse: Courbe en montagne (increasing, concave)
Neutral: linéaire
Seeking: courbe creuse
**U(x) est l’axe Y
what is the overconsuption of outcomes
Tendency of individuals to focus excessively on the results or outcomes of their financial decisions (e.g., gains or losses) rather than the process or rationality behind those decisions. This cognitive bias can lead to poor investment choices, emotional trading, and suboptimal long-term financial performance.
What are the 3 empirical facts of the prospect theory
- Certainty effect
- reflection effect
- isolation effect
What is the prospect theory
Explains how people make decisions under risk and uncertainty. It challenges traditional economic models (like Expected Utility Theory) by showing that people don’t always act rationally—instead, they are influenced by psychological biases.
Explain what is the certainty effect
People overweight outcomes that are considered certain, relative to outcomes which are merely probable. (Even if the other option has a higher expected value)
Explain what is the Reflection effect
People are risk averse in gains (play it safe to lock in value) and risk seeking in losses (try to avoid them)
Explain what is the isolation effect
To simply our choice between alternatives, people often disregard the past decisions and don’t look at the whole picture but only at the next decision they have to make.
**Look at the two stage example
What are the two phases of the prospect theory ? Explain each
- Editing phase: Before evaluating options, people mentally “edit” or frame them based on subjective perceptions.
- Evaluating phase: After editing, people assess the options using a value function and a probability weighting function.
What are the 6 components of the editing phase ? Explain each
- Coding: Outcomes are perceived as gains or losses relative to a reference point
- Combination: Merging identical outcomes to simplify choices
- Segregation: separating riskless components from risky ones.
- Cancellation: ignore common elements of different choices when comparing
- Simplification: Mentally round up probabilities
- Detection of dominance: removing options that are clearly worse without detailed evaluation.
What are the two ways (scales) that people use to asses options after the editing phase ?
- Value Function (S-shaped)
- Probability weighting function
Explain the probability weight function. (what people tend to do)
- People overweight small probabilities
- People underweight moderate-to-high probabilities
**Look graph slide 21
Explain the value function. (what people tend to do)
- Diminishing sensitivity: people feel less intense emotions as gains or losses grow larger. (S-shaped value)
- Loss aversion: Losses hurt approx. 2x more than equivalent gains
**See graph slide 21
What are the two important deviations from the expected utility framework found in the prospect theory
- Values are attached to changes rather than final states
- Decision weights do not coincide with stated probabilities.
In summary, state the four main elements of the prospect theory
- Reference dependence
- loss aversion (kink at reference point)
- Diminishing sensitivity
- probability weighting
