Prospect Theory: Understanding How People Make Decisions Under Risk

Question 1

According to Prospect Theory, when evaluating outcomes, people compare them to a:

Accepted Answer

Fixed reference point

Answer

Variable reference point

Answer

Random reference point

Answer

Weighted average of all past outcomes

Question 2

What is the framing effect, as it relates to Prospect Theory?

Accepted Answer

The tendency for different presentations of choices to influence people's decisions

Answer

The tendency for people to overestimate the probability of rare events

Answer

The tendency for people to underestimate the value of future gains

Answer

The tendency for people to be more risk-averse when making decisions for others

Question 3

According to Prospect Theory, when faced with decisions involving losses, people tend to be:

Accepted Answer

Risk-averse

Answer

Risk-seeking

Answer

Risk-neutral

Answer

Ambivalent towards risk

Question 4

In practical applications, how can Prospect Theory be utilized to enhance financial decision-making?

Accepted Answer

By aiding investors in recognizing and mitigating cognitive biases

Answer

By providing a formula to calculate optimal investment returns

Answer

By guaranteeing profitable investment decisions

Answer

By eliminating all risks associated with investment decisions

Question 5

In Prospect Theory, how does loss aversion contradict the traditional view of risk aversion?

Accepted Answer

Loss aversion challenges the idea that people always prefer certain outcomes to uncertain ones.

Answer

Loss aversion suggests that people are equally indifferent to gains and losses of the same size.

Answer

Loss aversion implies that people are more likely to take risks when they might gain.

Answer

Loss aversion supports the notion that people's risk tolerance stays the same in different situations.

Question 6

Which cognitive biases are central to Prospect Theory and how do they impact financial decision-making?

Accepted Answer

Loss aversion and framing effects

Answer

Overconfidence and optimism

Answer

Herd behavior and regret aversion

Question 7

In Prospect Theory, how does the shape of the value function reflect the differing ways people perceive gains and losses?

Accepted Answer

The value function has a steeper slope for gains than for losses, indicating a tendency to overvalue gains.

Answer

The value function is linear, suggesting that gains and losses are perceived equally.

Answer

The value function is symmetrical, implying that gains and losses are perceived in the same way.

Answer

The value function does not provide insights into how people perceive gains and losses.

Question 8

Which element is NOT central to Prospect Theory?

Accepted Answer

Utility maximization

Answer

Reference point

Answer

Loss aversion

Answer

Diminishing sensitivity

Question 9

According to Prospect Theory, individuals exhibit:

Accepted Answer

Greater risk aversion for potential losses

Answer

Greater risk tolerance for potential gains

Answer

Equal risk tolerance for both gains and losses

Answer

Varying risk tolerance based on external factors

Question 10

In Prospect Theory, the reference point represents:

Accepted Answer

The starting point for evaluating gains and losses

Answer

The point where a decision is reached

Answer

The most probable outcome

Answer

The average of all potential outcomes

Question 11

Loss aversion, as described by Prospect Theory, refers to:

Accepted Answer

The tendency to feel losses more acutely than gains

Answer

The desire to seek out risky investments for higher returns

Answer

The tendency to make purely rational decisions

Answer

The overestimation of the likelihood of negative events

Question 12

How does Prospect Theory explain the 'hot hand fallacy' in sports, where individuals believe they are on a winning streak after a series of successes?

Accepted Answer

Prospect Theory suggests that recent wins are overvalued, leading to the illusion of a 'hot hand'.

Answer

Prospect Theory predicts that individuals will consistently bet against teams on winning streaks.

Answer

Prospect Theory is unrelated to the 'hot hand fallacy' as it only applies to financial decision-making.

Answer

Prospect Theory suggests that individuals become more risk-averse after a series of losses, aiming to recoup their losses.

Question 13

In Prospect Theory, which cognitive bias causes people to give more weight to potential losses compared to potential gains?

Accepted Answer

Loss Aversion

Answer

Framing Effect

Answer

Reference Point Effect

Answer

Risk Aversion

Question 14

In Prospect Theory, how does cognitive inertia influence financial decision-making?

Accepted Answer

People stick to their financial plans even when circumstances change.

Answer

People become more cautious with money as they get richer.

Answer

People tend to expect higher returns after making recent gains.

Answer

People are more likely to sell stocks that are doing well than stocks that are losing value.

Question 15

How can integrating Prospect Theory with Mental Accounting enhance our understanding of financial decision-making?

Accepted Answer

By incorporating the way mental accounts influence the framing of gains and losses.

Answer

By assuming that individuals always have loss aversion.

Answer

By disregarding the significance of cognitive biases in financial decision-making.

Answer

By suggesting that individuals consistently make optimal and rational financial decisions.

Question 16

Which of the following is NOT a factor that contributes to cognitive biases in Prospect Theory?

Accepted Answer

Objective probabilities

Answer

Emotional attachment to outcomes

Answer

Framing effects

Answer

Bounded rationality

Question 17

How does the value function in Prospect Theory differ from the utility function in traditional economic models?

Accepted Answer

It is concave for gains and convex for losses

Answer

It is linear for both gains and losses

Answer

It is sigmoidal in shape

Answer

It is convex for gains and concave for losses

Question 18

According to Prospect Theory, individuals tend to be more sensitive to:

Accepted Answer

Potential losses

Answer

Potential gains

Answer

Both gains and losses equally

Answer

Neither gains nor losses

Question 19

In Prospect Theory, the reference point represents:

Accepted Answer

The starting point for evaluating outcomes

Answer

The most likely outcome

Answer

The outcome with the highest payoff

Answer

The outcome with the lowest payoff

Question 20

How does Prospect Theory explain the endowment effect?

Accepted Answer

People value possessions they own more than those they don't

Answer

People are more risk-averse when it comes to selling possessions

Answer

People are more likely to overpay for possessions they want

Answer

People are more likely to undervalue possessions they own

Question 21

According to Prospect Theory, individuals evaluate outcomes based on their:

Accepted Answer

Relative value

Answer

Absolute value

Answer

Expected value

Answer

Certainty equivalent

Question 22

The endowment effect, as described by Prospect Theory, refers to the tendency for individuals to:

Accepted Answer

Value items they possess more highly than those they do not possess.

Answer

Take greater risks when dealing with potential gains.

Answer

Experience losses as more distressing than gains of equal magnitude.

Answer

Make decisions based solely on rational calculations.

Question 23

How does framing influence financial choices, according to Prospect Theory?

Accepted Answer

It can lead to different decisions, even when the underlying options are objectively identical.

Answer

It only affects decisions involving potential losses.

Answer

It is only relevant in high-risk situations.

Answer

It has no impact on decision-making.

Question 24

How can Prospect Theory be utilized to enhance financial decision-making?

Accepted Answer

By acknowledging the influence of emotions and biases on decision-making.

Answer

By ignoring cognitive biases altogether.

Answer

By relying solely on complex mathematical models.

Answer

By accurately predicting future market trends.

Question 25

Which of the following experimental findings provides empirical support for Prospect Theory?

Accepted Answer

Individuals tend to avoid losses even at the potential expense of larger gains.

Answer

Individuals exhibit greater risk-taking behavior when pursuing gains.

Answer

Framing has no effect on investment decisions.

Answer

Emotions do not play a role in financial choices.

Question 26

Loss aversion, as described in Prospect Theory, can lead individuals to:

Accepted Answer

Hold onto losing investments for an extended period.

Answer

Sell winning investments prematurely.

Answer

Make no significant changes to their investment portfolio.

Answer

Only invest in risk-free assets.

Question 27

Which of the following individuals is most likely to exhibit loss aversion in their financial decisions?

Accepted Answer

A conservative investor prioritizing the preservation of capital.

Answer

An aggressive investor seeking high returns regardless of risk.

Answer

A dispassionate investor making decisions based solely on objective analysis.

Answer

An indifferent investor unaffected by gains or losses.

Question 28

What is the central concept of Prospect Theory?

Accepted Answer

Loss aversion

Answer

Seeking risk when potential gains are involved

Answer

Framing effects having no impact

Answer

Value function represented as a straight line

Question 29

Under Prospect Theory, how does risk aversion influence individuals' risk-taking behavior in financial situations?

Accepted Answer

Risk aversion discourages individuals from taking risks in financial decisions.

Answer

Risk aversion encourages individuals to embrace more risk in financial decisions.

Answer

Risk aversion has no bearing on individuals' risk-taking behavior in financial decisions.

Answer

Risk aversion exclusively affects investment choices and not spending habits.

Question 30

According to Prospect Theory, how do people generally respond to losses compared to gains of the same amount?

Accepted Answer

People tend to be more risk-averse with losses.

Answer

People tend to be more risk-averse with gains.

Answer

People tend to be more risk-seeking with gains.

Answer

People tend to be equally risk-averse with gains and losses.

Question 31

In Prospect Theory, the reference point against which gains and losses are evaluated is typically the:

Accepted Answer

Status quo

Answer

Expected outcome

Answer

Current market value

Answer

Previous investment return

Question 32

Which of the following is an implication of loss aversion in financial decision-making?

Accepted Answer

Investors may be reluctant to sell losing investments, even when it is financially advisable

Answer

Investors may take excessive risks in pursuit of gains

Answer

Investors may prematurely sell profitable investments

Question 33

According to Prospect Theory, individuals evaluate gains and losses:

Accepted Answer

Separately and non-linearly, with losses weighing more heavily than gains

Answer

Together and linearly

Answer

In a cumulative manner

Answer

Only in terms of potential gains

Question 34

Which of the following best describes the endowment effect?

Accepted Answer

Individuals tend to place a higher value on items they already own compared to similar items they do not own

Answer

Individuals are reluctant to sell assets at a loss

Answer

Individuals tend to overestimate the value of potential gains

Question 35

How does Prospect Theory differ from Expected Utility Theory?

Accepted Answer

It incorporates the influence of emotions and cognitive biases in decision-making

Answer

It focuses only on potential gains

Answer

It assumes rational and consistent behavior

Question 36

Which of the following is a practical application of Prospect Theory?

Accepted Answer

Developing strategies to reduce the impact of loss aversion bias in financial decision-making

Answer

Valuing real estate assets accurately

Answer

Predicting stock market fluctuations with certainty

Answer

Calculating investment returns precisely

Question 37

Prospect Theory primarily focuses on how people make decisions involving risk. What is its central idea?

Accepted Answer

Individuals place more weight on potential losses than on potential gains.

Answer

People only consider the absolute value of possible outcomes, disregarding whether they are gains or losses.

Answer

Decisions under risk are always rational and driven by expected value calculations.

Question 38

According to Prospect Theory, why is a $100 potential gain often valued less than a $100 potential loss?

Accepted Answer

Losses have a stronger psychological impact than gains.

Answer

Gains are discounted because we anticipate future gains.

Answer

People tend to overestimate the probability of experiencing losses.

Question 39

Which of these is NOT a key feature of the value function in Prospect Theory?

Accepted Answer

It is linear in the gain domain.

Answer

It is steeper in the loss domain.

Answer

It is concave in the loss domain.

Answer

It has a reference point of zero.

Question 40

In Prospect Theory, what does the reference point represent?

Accepted Answer

The point that separates perceived gains from perceived losses.

Answer

The amount of money someone is indifferent about gaining or losing.

Answer

The expected value of a risky choice.

Answer

The highest possible gain.

Question 41

The Allais Paradox demonstrates how Prospect Theory can explain:

Accepted Answer

Situations where people violate traditional expected utility theory.

Answer

The impact of how information is presented (framing effects).

Answer

The overestimation of unlikely events.

Question 42

Which of these strategies can help people make more rational financial decisions under risk, according to Prospect Theory?

Accepted Answer

Consider both potential gains and losses, and their potential emotional impact.

Answer

Focus solely on maximizing the expected value.

Answer

Ignore the emotions linked to financial outcomes.

Question 43

Prospect Theory suggests that individuals are generally more:

Accepted Answer

Risk-seeking when facing potential gains, and risk-averse when facing potential losses.

Answer

Risk-averse in both gain and loss situations.

Answer

Risk-seeking in both gain and loss situations.

Question 44

A lottery ticket with a 1 in 10 chance of winning $100,000 and a 9 in 10 chance of winning nothing is an example of:

Accepted Answer

A risky prospect with a positive expected value, but it might not be appealing because of loss aversion.

Answer

A risk-free prospect with a zero expected value.

Question 45

What do framing effects, as described in Prospect Theory, refer to?

Accepted Answer

The way information is presented influences decision-making.

Answer

The tendency to overestimate the likelihood of rare events.

Answer

The bias towards choosing options that are presented first.

Question 46

According to Prospect Theory, people are generally more averse to potential ______ than they are attracted to potential ______.

Accepted Answer

losses; gains

Answer

gains; losses

Answer

rewards; risks

Answer

risks; rewards

Question 47

Which of these scenarios best illustrates the concept of framing in Prospect Theory?

Accepted Answer

People tend to favor a treatment option with a 90% survival rate over one with a 10% mortality rate, even though both options have the same overall outcome.

Answer

People are more likely to buy a product when it is labeled as being on sale, even if the sale price is higher than the original price.

Answer

People tend to overestimate the probability of winning the lottery, even though the odds are extremely low.

Question 48

Prospect Theory suggests that individuals evaluate outcomes based on ______ relative to a ______.

Accepted Answer

changes; reference point

Answer

expected utility; subjective value

Answer

absolute values; changes

Answer

subjective value; expected utility

Question 49

The tendency to exaggerate the importance of small probabilities in decision-making is known as:

Accepted Answer

Probability weighting

Answer

Anchoring bias

Answer

Confirmation bias

Answer

Representativeness heuristic

Question 50

Which of the following is a criticism of Prospect Theory?

Accepted Answer

It fails to fully explain the wide range of individual differences in risk preferences.

Answer

It is overly complex and difficult to apply in practice.

Answer

It assumes that people always make rational decisions.

Question 51

An individual is presented with a gamble that offers a 50% chance of winning $200 and a 50% chance of losing $100. According to Prospect Theory, this individual is most likely to:

Accepted Answer

Decline the gamble due to loss aversion

Answer

Be indifferent to the gamble as the expected value is zero

Answer

Require more information before making a decision

Answer

Accept the gamble because the potential gain is larger than the potential loss

Question 52

Prospect Theory helps explain the phenomenon of the disposition effect in investing, which refers to the tendency to:

Accepted Answer

Sell profitable stocks too early and hold onto losing stocks too long

Answer

Buy stocks based on tips from friends and family

Answer

Invest in a diversified portfolio of assets

Question 53

The shape of the value function in Prospect Theory implies that:

Accepted Answer

People perceive losses more strongly than gains of the same magnitude.

Answer

People are equally sensitive to gains and losses of the same magnitude.

Answer

People are risk-seeking in the domain of gains and risk-averse in the domain of losses.

Question 54

Which of the following is an example of mental accounting, a concept related to Prospect Theory?

Accepted Answer

Treating money won from gambling differently than money earned from a job

Answer

Keeping a budget to track expenses and income

Answer

Setting long-term financial goals

Question 55

How can understanding Prospect Theory benefit individuals in their financial decision-making?

Accepted Answer

By raising awareness of cognitive biases and providing strategies to overcome them.

Answer

By eliminating the need for financial planning

Answer

By guaranteeing successful investment outcomes