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

According to prospect theory, which statement best describes how investors value outcomes?

Prospect theory says people judge outcomes as gains or losses relative to a reference point, not final wealth, and feel losses more strongly than equivalent gains. This loss aversion makes the value function steeper for losses and explains many departures from expected utility behaviour.

  1. AInvestors evaluate gains and losses relative to a reference point, and losses weigh more heavily than equal gainsCorrect
  2. BInvestors evaluate only final wealth and treat equal gains and losses symmetrically
  3. CInvestors are risk-seeking over gains and risk-averse over losses
  4. DInvestors assign probabilities objectively and linearly to all outcomes

Explanation

Prospect theory states that value is defined over gains and losses from a reference point, with a value function that is steeper for losses (loss aversion). Option 3 reverses the usual pattern, since people are typically risk-averse over gains and risk-seeking over losses.

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