Expected Utility Theory (Prospect Theory)

In financial literature, the modeling of individual decision-making processes has long been approached within the framework of rationality assumptions. The neoclassical approach assumes that investors fully and accurately evaluate all available information, aim to maximize utility, and make decisions accordingly. Within this framework, expected utility theory and the efficient markets hypothesis became foundational pillars of financial science. Expected utility theory long dominated as a normative model explaining how individuals ought to make decisions under uncertainty, while the efficient markets hypothesis attempted to explain rational market behavior by asserting that all information is fully reflected in asset prices.

However, experimental and empirical studies from the last quarter of the 20th century demonstrated that investor behavior often deviates from the assumptions of these theories. Phenomena such as decision biases, mental shortcuts, noise trading, and limited arbitrage have revealed that individuals can act far from rationality and that financial decisions are heavily influenced by psychological factors. These developments challenged the validity of traditional financial paradigms and laid the groundwork for the emergence of behavioral finance.

Behavioral finance is a discipline that examines the impact of human psychology on economic decision-making and adapts findings from psychology and sociology into financial theory. One of its most important theoretical foundations is Prospect Theory, developed by Daniel Kahneman and Amos Tversky in 1979. This theory explains how investors behave under risk and uncertainty and identifies irrational behaviors that traditional utility theory fails to account for.

The Emergence of Prospect Theory

In the early 1970s, research conducted by Amos Tversky and Daniel Kahneman revealed that individuals systematically rely on cognitive biases and mental shortcuts in decision-making. Their first major publication in 1974 focused on heuristics and the errors they produce; the 1979 paper “Prospect Theory: An Analysis of Decision under Risk” systematically introduced Prospect Theory. This theory aimed to explain deviations from rational assumptions in decisions made under risk and triggered a fundamental shift in financial literature.

Kahneman and Tversky’s experimental studies showed that individuals evaluate gains and losses not in absolute terms of wealth but relative to a reference point. Furthermore, they found that the pain of a loss is approximately twice as intense as the pleasure derived from an equivalent gain. These findings represented a crucial step in understanding investor behaviors that traditional expected utility theory could not explain.

Core Assumptions of Prospect Theory

1. Reference Point Dependence

While expected utility theory evaluates utility based on absolute levels of wealth, Prospect Theory holds that individuals perceive gains and losses relative to a specific reference point. This reference point is typically the current situation, the investor’s initial wealth, or their expectations. Consequently, the same absolute gain may be perceived differently depending on the reference point.

2. Loss Aversion

One of the most prominent features of Prospect Theory is loss aversion. Research indicates that the discomfort caused by a loss is roughly twice as strong as the pleasure derived from an equivalent gain. This leads investors to frequently exhibit behaviors aimed at avoiding losses rather than pursuing gains.

3. Framing Effect

The way decisions are made can change depending on how options are presented. The same economic outcome, framed as “gaining a profit” versus “avoiding a loss,” can lead investors to make different choices. This demonstrates that investors act based on cognitive perceptions rather than objective probabilities.

4. Probability Weighting

According to Prospect Theory, individuals do not evaluate probabilities linearly. Low-probability events are overweighted, while high-probability events are underweighted. As a result, investors may find low-probability, high-return investments more attractive than they objectively warrant, or they may underestimate the likelihood of high-probability losses.

Differences from Expected Utility Theory

Expected Utility Theory is a normative model that describes how individuals ought to behave, whereas Prospect Theory is a descriptive model that captures how individuals actually behave. In expected utility theory, individuals are assumed to be fully rational; in Prospect Theory, bounded rationality is the foundation. Expected utility theory analyzes decisions based on absolute wealth levels, while Prospect Theory considers relative gains and losses.

Behavioral Finance and Prospect Theory

Prospect Theory is widely regarded as one of the foundational pillars of behavioral finance. It is frequently invoked to explain how investors make decisions under cognitive biases, emotions, and psychological influences.

Mental Shortcuts and Biases

Mental shortcuts such as representativeness, availability, and anchoring, emphasized by Kahneman and Tversky, play a significant role in investor decision-making. While these heuristics accelerate information processing, they can also lead to systematic errors.

Investor Behavior

Prospect Theory is used to explain irrational behaviors known as market anomalies. For example, loss aversion leads investors to hold onto losing assets for extended periods while selling winning assets too early. This phenomenon, known in the literature as the “disposition effect,” is an example of irrational investor preferences.

Market Anomalies

While the efficient markets hypothesis claims that prices fully reflect all information and that systematic deviations are impossible, Prospect Theory demonstrates that investor psychology systematically influences price movements. Price bubbles, excessive volatility, and irrational exuberance can all be explained within the framework of Prospect Theory.

Impacts on Financial Decision-Making

Portfolio Selection

Due to loss aversion, investors tend to diversify their portfolios. However, fear of loss can also lead to overly cautious behavior, resulting in irrational portfolio allocations.

Currency and Stock Markets

Studies on Türkiye’s currency market have shown that investor behavior does not conform to the assumptions of the efficient markets hypothesis. In particular, semi-strong form efficiency has not been achieved. This suggests that investors exhibit behaviors explainable through psychological biases and Prospect Theory.

Risk Perception

According to Prospect Theory, individuals avoid risk in the domain of gains but seek risk in the domain of losses. This asymmetric attitude reveals that investors depart from rationality in their risk assessments.

Criticisms and Limitations

Although Prospect Theory has gained a significant place in financial literature, it has certain limitations. First, there is no clear explanation of how reference points are determined. Second, measuring probability weighting functions presents practical difficulties. Additionally, the extent to which investor behavior in different cultural and institutional contexts aligns with the theory’s predictions remains a subject of debate.