Prospect Theory

CFA Level III Ethics
#1

  • Prospect Theory assigns values to gains and losses rather than to final wealth , and probabilities are replaced by decision weights. There are 2 phases, framing and evaluating.

  • The three ways in which the prospect theory differs from the utility theory are:

    1. The probability-weighting function expresses the fact that people tend to overreact to small probability events but under react to mid-sized and large probabilities.
    1. The value function is asymmetric, implying that there is a bigger impact of losses than of gains. People are not risk-averse but rather are loss-averse.
    1. The value function is reference dependent. Same situations may evoke different preferences merely due to the framing effect.