Prospect Theory

CORE DEFINITION

Prospect theory is a behavioral economic theory proposed by psychologists Daniel Kahneman and Amos Tversky. One of its assumptions is that individuals have different attitudes toward risk based on their initial situation (reference point). This theory is one of the major achievements of behavioral economics. In the 1970s, Kahneman and Tversky systematically studied this field. For a long time, mainstream economics assumed that individuals are 'rational' when making decisions, but reality is not so; prospect theory incorporates asymmetric psychological utilities regarding gains and losses and the probabilities of outcomes, successfully explaining many seemingly irrational phenomena. Prospect theory has made outstanding contributions to the analysis of human judgment and decision-making under uncertainty, and Kahneman was awarded the Nobel Prize in Economics in 2002 for this. Prospect theory is a descriptive rather than prescriptive theory—it aims to explain phenomena, not to analyze how decisions should be made optimally. Prospect theory can be used for empirical research on the relationship between risk and return.