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

Under prospect theory as developed by Kahneman and Tversky, which statement is correct about how people evaluate outcomes?

Prospect theory says people judge outcomes as gains or losses from a reference point rather than final wealth, and a loss hurts more than an equal gain pleases. They are typically risk averse over gains and risk seeking over losses.

  1. AOutcomes are evaluated as gains and losses relative to a reference point, and losses loom larger than equal gainsCorrect
  2. BOutcomes are evaluated only by final wealth, and gains and losses are weighted equally
  3. CInvestors always maximise expected utility and are risk averse in both gains and losses
  4. DInvestors are risk seeking in gains and risk averse in losses

Explanation

Prospect theory states that value is assessed against a reference point and the value function is steeper for losses than gains. People tend to be risk averse in gains and risk seeking in losses, so the last option reverses this. The second and third options describe traditional expected utility thinking.

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