Contribution of Daniel Kahneman and Amos Tversky in Behavioral Finance

1. Contributions of Daniel
Kahneman and Amos Tversky
Submitted by
Dhrumil soni 37

2. Behavioural finance:
• Cognitive psychologists Daniel Kahneman and Amos Tversky are considered the
fathers of behavioural economics/finance.
• According to Traditional Finance, investors are, for the most part, rational “wealth
maximisers.” This theory says man acts only in a way that maximizes his returns
and minimizes his risks.
• Emotion and deeply ingrained biases influence our decisions, causing us to
behave in unpredictable or irrational ways.

3. Prospect theory:
• Prospect theory was originally developed by Daniel Kahneman and Amos Tversky in
1979. The theory is based upon the idea that we value losses and gains differently. More
specifically, it states that individuals would rather avoid loses than similar gains – because
losses create a stronger emotional effect than gains.
• In particular, people underweight outcomes that are merely probable in comparison with
outcomes that are obtained with certainty. This tendency, called certainty effects,
contributes to risk aversion in choices involving sure gains and to risk seeking in choices
involving sure losses.”

5. Certainty:
• In prospect theory, there are two types of certainty. The first is the certainty of gain, and
the second is the certainty of loss.
• The theory dictates that when faced with a potential gain, people will generally choose a
certain gain over a risk that rewards an even greater gain. This is also referred to as ‘risk-
averse’. However, the opposite is true with losses.
• When faced with the certainty of losses, the theory concludes that people take greater
risks in order to avoid the certainty of a loss.

6. Isolation effect:
• In prospect theory, the isolation effect occurs when people focus on differences between
options rather than similarities. This is to reduce the cognitive strain placed on our brains
and simplify the decision-making process.
Loss aversion:
• In prospect theory, loss aversion is where an individual’s fear of losses is greater than
their joy of gains. In other words, people prefer to minimize losses than maximize gains.

7. Expected Utility theory vs Prospect theory:
• Expected Utility theory assumes individuals will choose the outcome which gives
maximum utility given the probability of outcomes.
• Prospect theory allows for the fact that individuals may choose a decision which doesn't
necessarily maximise utility because they place other considerations above utility.