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

Prospect theory, a cornerstone of behavioural finance, states that investors evaluate outcomes relative to a reference point. A client is offered a choice: a certain loss of ₹50,000, or a 50% chance of losing ₹1,00,000 and a 50% chance of losing nothing. Both have the same expected loss of ₹50,000. According to prospect theory, what is the client most likely to choose and why?

The client will most likely choose the gamble. Prospect theory says people are risk seeking when facing losses relative to a reference point, preferring a chance to avoid loss over a sure loss, even though both options have the same expected loss of ₹50,000.

  1. AThe certain loss, because investors are risk averse in the domain of losses
  2. BThe gamble, because investors tend to be risk seeking in the domain of lossesCorrect
  3. CThe certain loss, because the expected values differ
  4. DNeither, because prospect theory predicts indifference when expected values are equal

Explanation

Expected loss: certain option is 50,000; gamble is 0.5×1,00,000 + 0.5×0 = 50,000, so they are equal. Prospect theory says people are risk averse for gains but risk seeking for losses, because losses loom larger and a chance to avoid loss is attractive. So the gamble is likely chosen. Indifference is predicted by expected utility theory, not by prospect theory.

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