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Prospect Theory

In: Finance and the Behavioral Prospect

Author

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  • James Ming Chen

    (Michigan State University)

Abstract

This chapter explores prospect theory’s depiction of the impact of fear and greed on financial markets. Prospect theory posits that the human evaluation of uncertain gains and losses departs from a purely rational account of expected utility in three crucial ways. First, humans pay heed to a reference point, whether it is the price paid for a security or a target rate of return. Second, humans hate losing more than they like winning. Third, humans grow less sensitive to the magnitude of changes in welfare as gains or losses increase. Critically, diminished sensitivity applies to gains as well as losses. The resulting “fourfold pattern” of human responses to uncertainty provides a far more complete and persuasive account of risk-averse as well as risk-seeking behavior.

Suggested Citation

  • James Ming Chen, 2016. "Prospect Theory," Quantitative Perspectives on Behavioral Economics and Finance, in: Finance and the Behavioral Prospect, chapter 0, pages 181-212, Palgrave Macmillan.
    • Handle: RePEc:pal:qpochp:978-3-319-32711-2_8
    DOI: 10.1007/978-3-319-32711-2_8
    as

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