Prospect theory explains how individuals evaluate risk and reward from "summary" of Beyond Greed and Fear:Understanding Behavioral Finance and the Psychology of Investing by Hersh Shefrin
Prospect theory provides a framework for understanding how people make decisions in situations involving risk and uncertainty. According to this theory, individuals do not evaluate outcomes in absolute terms, but rather in relation to a reference point. This reference point can be influenced by a variety of factors, such as past experiences, expectations, or social norms. When evaluating potential outcomes, individuals tend to focus more on potential losses than on potential gains. This asymmetry in decision-making is known as loss aversion. People are generally more sensitive to losses than to equivalent gains, leading them to take greater risks in order to avoid losses. In addition to loss aversion, prospect theory also describes the concept of diminishing sensitivity. This means that individuals are less sensitive to changes in outcomes as they move further away from the reference point. For example, a $100 loss may have a greater impact on a person's decision-making than a $100 gain, even though they are of equal magnitude. Another important aspect of prospect theory is the idea of framing. The way in which information is presented can influence how individuals perceive risks and rewards. People tend to be more risk-averse when faced with choices framed in terms of potential gains, and more risk-seeking when faced with choices framed in terms of potential losses.- Prospect theory helps explain why individuals may deviate from traditional economic models of rational decision-making. By taking into account the psychological factors that influence how people evaluate risk and reward, this theory offers valuable insights into human behavior in financial and investment contexts.
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