Decision Making And The Prospect Theory - 1490 Words

Introduction Decision making is the act of choosing the best solution to a problem depending on its value and the preferences of the decision maker. In the first part of this essay, we will explore the Expected Utility theory and the Prospect Theory, which are normative and descriptive approaches to making decisions with inherent risks. The first part of the essay argues that Expected Utility Theory is a less viable hypothesis to decision making and is fundamentally flawed compared to the Prospect Theory in description and function. Prospect theory is a better model for decision making because firstly, decisions are not often made objectively and can be affected by decision weights. Secondly, individuals are not risk averse as suggested by the utility theory, but are instead loss averse. Lastly, individuals evaluate decisions not by their final resting utility, but instead they react dependently based on their reference point. The second part of the essay will delve into the topic of heuristics t hat emerge in investment decision making. The main biases that investors make include disposition effect, anchoring and adjustments bias and overconfidence. Part 1. Expected utility theory states what rational decision makers should do in order to maximise their utility. On the other hand, Prospect Theory describes how individuals make decisions when faced with perceived risk and uncertainty. Utility can be explained by how much an individual values an extra unit of wealth.Show MoreRelatedProspect Theory And Expected Utility Theory1419 Words   |  6 PagesEssay Introduction Negotiations and decisions are act as key counterparts in every business. A clear definition as well as the recognition of core elements surrounding the decision making process is required to reach a suitable decision. These approaches purpose to be achieved clear concerns before a final decision-making. This paper will outline prospect theory and discuss the differences between prospect theory and expected utility theory. Following will be, as explanation of the biases and heuristicsRead MoreThe Psychological Study Of Decision Making Began After Theories1306 Words   |  6 PagesThe Psychological study of decision making began after theories were introduced in order to understand an individual’s thought process when faced with decisions. The aim of these theories were to examine whether or not humans are rational decision makers by introducing probabilities and the evaluation of risk. This essay will evaluate The Expected Utility Theory, The Prospect Theory and other potenti al influences to decision making. As well as state both the strengths and weaknesses of them, in orderRead MoreEffective Appraisal Approaches And Its Influence On Investment Decision Making1441 Words   |  6 Pagesof equipment or inventory by owner in order to improve future business. (Kahraman, 2011) Moreover, the part of decision-making acts a crucial role in business investment that depends upon the investor’s profit expectation, the availability to finance the investment and the potential cost of assets. (Virlics, 2013) However, risk and uncertainty are the basic terms to the decision-making framework. Risk can be defined as the probability of outcomes or loss that is caused by internal or external vulnerabilitiesRead MoreIndividual Risks Perception : Risk Perception906 Words   |  4 Pages2.1. Individual risk perception Risk perception is the person’s subjective uncertainty about what she could lose or gain from a transaction (Cox Rich, 1964). In a similar vein, Ricciardi (2008) defines perceived risk as â€Å"[†¦] the subjective decision making process that individuals employ concerning the assessment of risk and the degree of uncertainty†. Risk perception is related to the amount, possibility, and exposure to loss (MacCrimmon Wehrung, 1988), to confidence in individually assessedRead MoreEffective Appraisal Approaches And Its Influence On Investment Decision Making1419 Words   |  6 Pagesof equipment or inventory by owner in order to improve future business. (Kahraman, 2011) Moreover, the part of decision-making preforms a crucial role in business investment that depends upon the investor’s profit expectation, the availability to finance the investment and the potential cost of asset. (Virlics, 2013) However, risk and uncertainty are the basic terms to the decision-m aking framework. Risk can be defined as the probability or threat of outcomes or loss that is caused by internal orRead MoreMaps Of Bounded Rationality : Psychology For Behavioural Economics960 Words   |  4 Pagesintuitive thinking and how it guides our decision-making. Although primarily aimed at the field of psychology, it is an interdisciplinary article with applications in economic theorising. Kahneman attempts to differentiate between two systems of thought, one of intuition (system 1) and one of reasoning (system 2), and argues that many judgements and choices are made intuitively, rather than with reason (a slower and more deliberate process). Intuitive decision making, which encompasses heuristics, althoughRead MoreTheory Of Games And Economic Behaviour968 Words   |  4 Pagesbehavioural decision theory, current findings suggest that heuristics and biases have a significant impact on individual decision making. Rationality can only go so far in explaining individual de cision making. A large part of early research into decision theory was based on the economic or normative approach, which tries to predict the actions of a so called ‘rational decision maker’. Although Bernoulli (1738) was the first to introduce the concept of utility into decision making, it was VonRead MoreThe Contributions Of The Endowment Effect Essay1600 Words   |  7 Pagescognitive mechanisms, and hypotheses relevant to age. Theoretical Framework A major theory linked to the endowment effect is Tversky and Kahneman’s (1979) prospect theory. This theory provided new insight into the decision-making process, and went further than previous theory, the utility theory, to explain how decisions are made. Tversky and Kahneman describe prospect theory as a decision between gains and losses, or prospect and gambles as it is referred to in their 1979 paper. With every choice we makeRead MoreThe And Decision Making : A Critical Literature Review934 Words   |  4 Pagesinformation processing has emerged from decades of research into widespread use of decision heuristics by individuals. Tversky Kahneman (1986) demonstrated how individuals violate normative decision rules by employing decision heuristics (e.g. representativeness, availability, and anchoring) to solve complex problems. These cognitive aspects of decision making play a primary role in the investment selection decision process when weighing up the benefits and cost s from choice. These cognitive biasesRead MoreStudy Stock Market Trends : Ron Insana. Investments Don t Always Work As Planned On Wall Street1487 Words   |  6 Pagesare now developing in faster intervals and in different sectors of the market. Experience flattens out the makings of a bubble and experience also benefits investors by means of avoiding repeated errors in a particular investment. Game theory applies to industrial organizations, labor markets and pricing. Game theory rarely applies to finance. The Nash equilibrium is a term used in game theory to describe equilibrium where each player s strategy is optimal given the strategies of all other players