Prospect Theory

Prospect theory refers to a model from the world of behavioral finance that describes how people make decisions in the context of risk. In general, prospect theory involves decision making based on the assessment of gains and losses relative to a reference point rather than the final outcome. Loss aversion and framing come into play, and the reference point that is selected is critical. For example, the reference point for many annuity purchase decisions is the impact on current financial wealth rather than future income and consumption (the actual outcome). Gains and losses are likely assessed relative to the reference point which can lead to less than optimal financial decisions.