Prospect Theory

Market dynamics
Explain Prospect Theory and its relevance to stock returns.

Hint

Answer

Prospect Theory, developed by Kahneman and Tversky, proposes that people value gains and losses differently, leading to decision-making that deviates from traditional rational models. In terms of stock returns, it suggests investors are more sensitive to losses than to equivalent gains and may make irrational decisions based on this asymmetry. This theory is relevant as it provides insight into investor behavior, especially under uncertainty, and helps in understanding market anomalies and investor decision-making processes.