Utility vs Prospect Theory

Prospect Theory (loss averse):

  • People risk averse for high probaility of gain / low probability of loss
  • People risk taker for high probaility of loss / high probability of gain

Utility Theory (risk averse):

  • People risk averse for low losses at low income level
  • People risk taker for high gain at high income level

Am I correct?

Another point: under Prospect Theory people tend to overreact to small probability events and underreact to mid/large probability events…how it is linked to the description above reported?

Many thanks!

Here is how I think of the two:

Utility Theory

  • Traditional finance perspective
  • Less risk is better than more risk, all else equal. So investors are risk-averse
  • Individuals will seek to maximize their utility/satisfaction within the constraints imposed by their budget (ie. income)
  • You like gains to the same degree you dislike losses

Prospect Theory

  • Behavioural finance perspective
  • Individuals don’t focus so much on the probable expected outcomes, but rather the impact (or weight) of a given deviation from their current level of wealth
  • Therefore, this is where individuals are proven to show they dislike losses twice as much as they like gains (due to behavioural, not “rational economic man”) = loss aversion
  • Also, under PT we are more likely to lock in gains due to fear of loss

Sorry I forgot to highlight that I was referring to the double inflation utility curve