PROSPECT THEORY APPLICATIONS IN FINANCE

Abstract

“There is nothing as dangerous as the pursuit of a rational investment policy in an irrational world” JMK This is a comprehensive study of how people form decision about the prospects, its people’s decision under uncertainty. In the first part it deals with the inception of the prospect theory in behavioural finance taking in to account the drawbacks of the Expected Utility Theory .i.e. that’s is what were the main problems with the Expected Utility Theory that leads Daniel Kahneman and Amos Tversky to invent this descriptive theory(1979,1992). The Expected Utility Theory of Von Neumann and Morgenstern (1944) is a powerful tool for the analysis of decisions under risk. However people in both experimental and real life situations frequently do not conform to the NM axioms. Hence here comes the prospect theory which says the carriers of the value are gain and loss not the final value of the wealth. The investor has a greater sensitivity to losses than gains of the same magnitude. In the traditional models an agent evaluates a new gamble by merging it with his pre existing risks and checking if the combination is attractive, but in experimental setting people often seems to evaluate a new gamble in isolation. This is called narrow framing, get utility directly from the outcome of the gamble not just indirectly from its contribution to total wealth. For example. Mr A offers Mr B the choice between the following two gambles Gamble 1: win $240 with 100% Expected Utility =$240 Gamble 2: win $400 with 50% Win $100with 50% Expected Utility=$250 The expected utility of gamble 2 is higher than gamble 1. Therefore if people were to choose rationally they would have picked gamble 2 as it gives higher expected utility. However the research on prospect theory shows that the majority of people pick gamble 1 which has the lower expected utility. The second part of this study talks about the application of the prospect theory in behavioural finance. It's hard to find a place today where concepts of behavioural finance aren’t being applied to real-world situations. The last part of this paper talks about the drawbacks of prospect theory, is there any way to make it work better and can play a greater role in behavioural finance.