Prospect Theory and the Financial Markets: A Review

Abstract

The Prospect Theory as proposed by Kahneman and Tversky (1979) has emerged as a widely accepted theory of decision-making, thanks largely to the persistence of observed anomalies in the trading of financial products – specifically, the existence of an unusually large premium on equities, and the tendency to hold on to losing investments (disposition effect). Questions about the true nature and extent of reference-dependent loss aversion as manifested by these phenomena, however, remain. In particular, for countries like the Philippines with relatively shallow capital markets, there is a need to reconcile financial education and advice with the reality of systematically irrational investor sentiment to facilitate greater financial market participation.