Question

Behavioral Finance is subject

1. Explain carefully, in your own words, how the prospect theory's predictions of people's decision making under uncertainty differ from those of expected utility theory.  

Finance

Answer 1

Prospect theory and expected utility theory both focuses on the way people make decision when they are presented with scenario. The prospect theory focuses on the concept of loss aversion where the focus is on that people behave differently when they are potential loss and gain scenario, they make decision based on relative preference. For example an investor might choose a lower utility outcome if the risk is low, that means there is high certainty of that outcome or the investor might choose to accept a lower utility if the uncertainty associated with that outcome is least so when presented with potential gain and loss scenario the investor focuses on reducing the relative uncertainty of the outcome, even if it comes at the cost of letting go of the utility. The expected utility theory on the other hand focuses on the decision making based on absolute basis not relative, lets say there is an opportunity where there is a probability of 50% gain of 100 and 50 % of loss of 50, so the (0.50*100 – 0.50*50) = 25 or another opportunity where the 50% of gain is 200 and 50% chance of loss is 150 (0.50*200 – 0.50*150) = 25, according to expected utility theory, the investor would be indifferent between the two because the outcome is same but that might not be the case in the case of prospect theory.