Briefly (no more than 3 sentences) explain the differences andsimilarities between the model of disappointment...

Briefly (no more than 3 sentences) explain the differences and similarities between the model of disappointment and the prospect theory.

Expert Solution

Prospect Theory (Tversky and Kahneman) attempts to describe a regularly observed phenomena where potential gain or potential loss of a situation is given undue emphasis in decision-making; when someone has a decision to make they will choose the option that offers the best ratio of potential value to potential risk.

This theory takes into account the odds of a certain outcome as opposed to just looking at absolute outcomes, and is something of a substitutute for traditional Expected Utility Theory.

Frame of Reference is important in Prospect Theory, and one critical difference from Expected Utility theory (same utility if net gain is the same, regardless of whether the gain was from a single win or 5 losses and 1 win) is Loss Aversion or avoiding disappointment; "losses loom larger than gains” i.e. the pain of losing is psychologically about twice as powerful as the pleasure of gaining.

Traders and investors have known about loss aversion for a long time; there's a saying in these circles: "fear is stronger than greed".

tl;dr: Prospect THeory is more general, Loss Aversion or model of disappointment is an important part (but still just one part) of the larger more general framework.

Rahul Sunny answered 2 years ago

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