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NISM Certifications · NISM-Series-X-B: Investment Adviser (Level 2) · Basics of Behavioural Finance

According to prospect theory, which statement about how people value outcomes is correct?

Prospect theory holds that people judge outcomes as gains or losses relative to a reference point, and that losses hurt more than equivalent gains please. It also implies risk aversion in gains and risk seeking in losses, unlike expected utility theory.

  1. AGains and losses are valued relative to a reference point, and losses loom larger than equal gainsCorrect
  2. BFinal wealth levels alone determine utility, and losses and gains are weighted equally
  3. CInvestors always maximise expected value using objective probabilities
  4. DInvestors are risk-seeking in gains and risk-averse in losses

Explanation

Prospect theory (Kahneman and Tversky) says value is assessed as gains or losses from a reference point, with a steeper curve for losses (loss aversion). People tend to be risk-averse in gains and risk-seeking in losses, so the last option is reversed.

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