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CFA Level I · CFA Level I Exam · The Behavioral Biases of Individuals

Prospect theory, a cornerstone of behavioral finance, differs from expected utility theory most likely because prospect theory assumes that people:

Prospect theory assumes people judge outcomes as gains or losses relative to a reference point, and losses hurt more than equal gains please. Expected utility theory instead evaluates final wealth with objective probabilities and consistent risk aversion, without any role for framing.

  1. Aevaluate outcomes as gains or losses relative to a reference point, with losses weighing more heavily than equal gainsCorrect
  2. Bassign probabilities to outcomes objectively and evaluate final wealth levels
  3. Care risk averse at all levels of wealth and ignore how choices are framed

Explanation

Prospect theory uses a reference point and an asymmetric value function in which losses loom larger than equal gains. Expected utility uses final wealth, objective probabilities and consistent risk aversion, so the other options describe expected utility or are incorrect.

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