Prospect Theory in Modern Financial Markets: Implications for Risk and Reward

Abstract

Purpose: This review research paper aims to explore the application of Prospect Theory in contemporary financial markets and its consequential effects on the perception of risk and reward by investors. The purpose is to deepen our understanding of how this psychological framework influences decision-making processes and subsequently shapes investment behaviors in the complex landscape of modern finance.

Theoretical Framework: The paper is firmly rooted in the Prospect Theory, a seminal work in behavioral economics developed by Kahneman and Tversky. This framework departs from traditional rational choice theory by emphasizing the significance of cognitive biases and heuristics in decision-making. By examining its relevance within modern financial markets, the paper seeks to unveil how individuals' perceptions of risk and reward deviate from traditional economic models.

Design/Methodology/Approach: The research adopts a comprehensive literature review approach, analyzing a wide range of empirical studies, experimental research, and case analyses. By synthesizing findings from various sources, the authors construct a coherent narrative that highlights the practical application and limitations of Prospect Theory in financial market contexts.

Findings: The paper's findings underscore the robustness of Prospect Theory in explaining deviations from rational behavior in modern financial markets. It reveals that investors tend to exhibit loss aversion, framing effects, and reference dependence, which influence their risk-taking tendencies and perception of rewards. Moreover, the research elucidates how Prospect Theory's insights can shed light on asset pricing anomalies, market volatility, and investment bubbles.

Research, Practical & Social Implications: The implications of this research are multifaceted. From a research standpoint, the paper enriches the literature on behavioral finance by providing an updated understanding of Prospect Theory's application in today's financial markets. On a practical level, the insights derived from this study can guide financial professionals and policymakers in designing more effective investment strategies and risk management approaches. Furthermore, the social implications are significant, as a deeper comprehension of how psychological factors impact financial decisions can contribute to enhancing financial literacy and investor education.

Originality/Value: This paper contributes to the originality of the literature by bridging the classic concepts of Prospect Theory with the complexities of contemporary financial markets. Its value lies in offering a comprehensive synthesis of diverse research findings and presenting a coherent framework that enhances our understanding of behavioral influences on investment decisions.