Daniel Kahneman and Amos Tversky developed Prospect Theory in 1979
Prospect theory
Daniel Kahneman and Amos Tversky developed Prospect Theory in 1979
The theory introduces a value function defined over gains and losses, rather than final wealth. It also includes a probability-weighting function that reflects the tendency of individuals to overweight small probabilities and underweight large ones. This challenges the expected utility theory, which assumes perfectly rational agents.
Example
A person might prefer a guaranteed $50 over a 50% chance to win $100, even though the expected value of the gamble is higher.
Understanding Prospect Theory helps explain why people make irrational decisions when faced with risk.
Related concepts
Markowitz model
Harry Markowitz introduced the mean-variance optimization model in 1952
Recency bias
Recency bias overvalues recent events in decision-making
Risk parity
Risk parity allocates based on risk contribution, not capital allocation
Permanent income hypothesis
Permanent income hypothesis (PIH) focuses on permanent income for consumption decisions
Straddle
Straddle strategy profits from large price movements in either direction
Skin in the Game (book)
Nassim Nicholas Taleb's book "Skin in the Game" emphasizes shared risk for fairness and efficiency
Educational content, not financial advice.
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