Prospect Theory vs. Expected Utility Theory The Prospect Theory and the Expected Utility Theory are two competing approaches to decision-making in be...
The Prospect Theory and the Expected Utility Theory are two competing approaches to decision-making in behavioral finance.
Prospect Theory:
Focuses on the potential for gain and the temporal distance between an action and its consequences.
Individuals are rational actors who seek to maximize their expected utility or satisfaction.
They make decisions based on the expected value of the potential outcomes they might experience.
In simpler terms, it suggests that people would choose the option that offers the highest potential gain or the option that provides the highest probability of receiving a desirable outcome.
Expected Utility Theory:
Emphasizes the utility an individual derives from an outcome, regardless of its probability.
Individuals are risk-averse and choose the option that provides them with the highest expected utility while minimizing potential losses.
It suggests that people would choose the option that offers the most immediate source of satisfaction or the option that provides the highest level of utility regardless of the probability of its occurrence.
Key Differences:
| Feature | Prospect Theory | Expected Utility Theory |
|---|---|---|
| Focus | Potential for gain | Expected utility |
| Timeframe | Temporal distance between action and consequence | Immediate and potential future satisfaction |
| Decision-making process | Maximizing expected value | Choosing the option with the highest expected utility |
| Risk aversion | High | Low |
Examples:
Conclusion:
Both theories offer valuable insights into decision-making in behavioral finance. Prospect theory helps explain why people make risky choices by focusing on potential gains, while Expected Utility theory helps explain why people choose safe options with lower expected values