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Kahneman's Prospect Theory Analysis

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Daniel Kahneman and Amos Tversky published a paper in the journal Econometrica titled “Prospect Theory: An Analysis of Decision under Risk” in 1979. This paper accomplished two things. First, they revealed that people in laboratory settings systematically violate the predictions of expected utility theory. Second, they presented a new model of risk attitudes called “prospect theory”, which captures behavioural aspects that expected utility theory cannot. Over 35 years has passed since Kahneman and Tversky’s papers on prospect theory was first published. Their paper have been cited over tens of thousands of times and were decisive in awarding Kahneman the Nobel Prize in economic sciences in 2002. Prospect theory is still widely viewed as the …show more content…

The principal idea in prospect theory is that individuals derive utility from “gains” and “losses” measured relative to a reference point. However, it is every so often indistinct to define specifically what a gain or a loss is – especially since Kahneman and Tversky offered relatively little guidance on how the reference point is determined (Barberis, 2013). One example this is predicting what kind of portfolio an investor will hold. Which “gains” and “losses” is the investor thinking about? Are they gains and losses in the value of specific stocks, in the value of total stock market holdings, or in overall wealth? Considering that the investor specifies his gains and losses in the value of stock market holdings – does a “gain” then mean that the return on the stock market was positive? Or does it mean that the stock market return exceeded what the investor expected to earn, or the risk-free rate? Also, which time period is considered? Is it annual gains and losses or monthly or weekly …show more content…

Since prospect theory solve some of the problems with expected utility theory, is it only reasonable to believe that this model should be mentioned during these courses. This leads me to question; is prospect theory really that hard to apply in economics? Or are we just used to the idea of implementing the expected utility model, as always. My personal opinion is that prospect theory need to be further investigated, both by researchers – and in the

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