Decision-making under uncertainty is a central topic in finance, influencing how investors evaluate risk and return. Traditional financial theory assumes that individuals behave rationally and consistently when making decisions. However, empirical evidence suggests that real-world behaviour often deviates from these assumptions.
At Amsshare, we analyse financial models and behavioural patterns that influence investment decisions. Understanding the theoretical foundations of decision-making, as well as their limitations, is essential for interpreting market behaviour and improving financial modelling approaches. This article provides an overview of two key theories that explain how individuals make decisions under uncertainty.
Summary
This article provides an overview of two prominent psychological theories in finance: the Expected Utility Theory (EUT) and the Prospect Theory (PT). The EUT is a normative framework that describes how individuals should make decisions, based on rational assumptions and a set of core principles.
The EUT is built on four key axioms: completeness, transitivity, continuity, and independence. It assumes that individuals evaluate outcomes based on total wealth and exhibit risk aversion. However, empirical evidence shows that actual decision-making behaviour often deviates from these assumptions.
The Prospect Theory (PT), developed by Kahneman and Tversky, provides a more realistic, descriptive view of decision-making. Instead of focusing on total wealth, it evaluates outcomes in terms of gains and losses. The theory highlights three key behavioural patterns: risk aversion over gains, risk-seeking behaviour over losses, and loss aversion, where losses have a stronger impact than gains.
In addition, the PT accounts for the distortion of probabilities, where individuals tend to overweight low probabilities and underweight high probabilities. These behavioural insights explain why individuals often make decisions that differ from traditional rational models.
The article concludes by comparing both theories and showing that the Prospect Theory provides a more accurate framework for understanding real-world decision-making. These insights are relevant for interpreting investor behaviour and for developing more realistic financial models.
