It is stated that quantitative elements of prospect theory resembles the expected utlity theory except for these differneces- 1) Values are attached to changes rather than the final states 2) decisions weights need not coincide with the probability. I don’t understand the second point here. Can somebody please explain? Thanks.
The objective probabilities are 60% green, 40% red.
Your subjective weights are 80% green, 20% red. (“Sixty-forty? I ain’t buyin’ it.”)
I have tried searching around, reading the example on CFAI book but just don’t get " 1) Values are attached to changes rather than the final states"
Hope someone can kindly explain, thank you.
It is the theory that people are not fully rational when faced with probabilistic outcomes and they rather look at the prospects of one particular outcome rather than the mathematical expected outcome. The classic example is this:
Choose one of the three alternatives as best:
80% chance to win 100, 20% chance to lose 350
50% chance to win 100, 50% chance to lose 80
10% chance to win 190, 90% chance to lose 10
In all cases the expected outcome is +10, but people will choose different answers based on how much the would like to win or how much they are afraid to lose. Which one would you choose?
Thank you Krokodlillizm!