Investments, tenth edition

  Prospect Theory   

   Prospect  theory    

modifies the analytic description of ratio-

nal risk-averse investors found in stan-

dard financial theory.  

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     Figure  12.1 , 

panel A, illustrates the conventional 

description of a risk-averse investor. 

Higher wealth provides higher sat-

isfaction, or “utility,” but at a dimin-

ishing rate (the curve flattens as the 

individual becomes wealthier). This 

gives rise to risk aversion: A gain of 

$1,000 increases utility by less than 

a loss of $1,000 reduces it; therefore, 

investors will reject risky prospects 

that don’t offer a risk premium. 

  Figure 12.1 , panel B, shows a com-

peting description of preferences char-

acterized by “loss aversion.” Utility 

depends not on the  level  of wealth, as 

in panel A, but on  changes  in wealth 

from current levels. Moreover, to the 

left of zero (zero denotes no change 

from current wealth), the curve is convex rather than concave. This has several impli-

cations. Whereas many conventional utility functions imply that investors may become 

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 Meir Statman, Kenneth L. Fisher, and Deniz Angier, “Affect in a Behavioral Asset-Pricing Model,”  Financial 

Analysts Journal  64 (2008), 20–29. 

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 Prospect theory originated with a highly influential paper about decision making under uncertainty by 

D. Kahneman and A. Tversky, “Prospect Theory: An Analysis of Decision under Risk,”  Econometrica  47 (1979), 

pp. 263–91.