Prospect theory and Financial Decisions

Prospect theory, developed by Daniel Kahneman and Amos Tversky in the late 1970s, has had a profound impact on the fields of behavioral economics and decision-making. This theory is significant because it challenges the traditional economic assumption that individuals always make rational choices based on expected utility. Instead, it recognizes that human decision-making is often influenced by cognitive biases and emotions. Prospect theory introduces the concept of "loss aversion," which suggests that people tend to weigh potential losses more heavily than equivalent gains, leading to risk-averse behavior in the domain of gains and risk-seeking behavior in the domain of losses. This psychological insight has practical implications for various fields, from finance to public policy, as it provides a more accurate framework for understanding and predicting human decision-making, ultimately improving our ability to design effective incentives, interventions, and strategies.