Prospect theory

A theory of decision-making under risk in which people evaluate outcomes relative to a reference point and weigh losses more heavily than equivalent gains.

Value function: A function that maps outcomes to subjective values rather than treating them as objective amounts. Prospect theory's value function is defined over gains and losses relative to a reference point.
Daniel Kahneman: An Israeli-American psychologist whose research on judgment and decision-making earned the 2002 Nobel Memorial Prize in Economic Sciences. He co-developed prospect theory with Amos Tversky.
Endowment effect: The tendency for people to value an object more once they own it. Reference dependence and loss aversion help explain why giving up ownership feels costly.
Cumulative prospect theory: An extension of prospect theory that applies probability weighting to cumulative distributions of outcomes. It addresses shortcomings of the original model and accommodates more general risky prospects.
Loss aversion: The tendency for losses to have greater psychological impact than equivalent gains. It captures the theory's central asymmetry between losses and gains.
Amos Tversky: An Israeli cognitive psychologist known for foundational research on judgment, choice, and heuristics. His experiments and collaboration with Kahneman shaped the theory's original account.
Disposition effect: Investors' tendency to sell winning assets too early and hold losing assets too long. Evaluating returns relative to purchase prices can make selling a loss psychologically difficult.
Rank-dependent expected utility: A decision theory that transforms cumulative probabilities while retaining utility over final outcomes. It shares probability weighting with cumulative prospect theory but does not require reference-dependent values.
Reference dependence: The evaluation of outcomes as changes from a reference point rather than as final states. The theory measures outcomes as gains or losses relative to a reference point.
Expected utility theory: A model of choice under risk that ranks options by the probability-weighted utility of their outcomes. Prospect theory was developed to explain reliable choices that violate this model's predictions.

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