Explain the concept of prospect theory in the context of behavioral finance.

Prospect theory is a concept in behavioral finance that seeks to explain how individuals make decisions under conditions of uncertainty. It was developed by psychologists Daniel Kahneman and Amos Tversky in the 1970s as an alternative to the traditional rational choice theory.

According to prospect theory, individuals do not always make decisions based on rational calculations of expected utility. Instead, their decisions are influenced by cognitive biases and heuristics that can lead to systematic deviations from rationality.

One key aspect of prospect theory is the idea that individuals evaluate outcomes relative to a reference point, rather than in absolute terms. This reference point can be influenced by various factors, such as past experiences, social norms, or expectations. Individuals tend to be risk-averse when evaluating gains relative to the reference point, meaning they are more sensitive to potential losses than potential gains. Conversely, they tend to be risk-seeking when evaluating losses relative to the reference point, meaning they are more willing to take risks to avoid losses.

Another important concept in prospect theory is the notion of diminishing sensitivity. This suggests that individuals are less sensitive to changes in outcomes as they move away from the reference point. For example, the difference between gaining $100 and gaining $200 is perceived as larger than the difference between gaining $1,100 and gaining $1,200. This diminishing sensitivity can lead to risk-seeking behavior in the domain of losses and risk-averse behavior in the domain of gains.

Prospect theory also introduces the concept of framing, which refers to how choices are presented or framed to individuals. The way a decision is framed can significantly influence individuals' preferences and choices. For example, individuals may be more risk-averse when a decision is framed in terms of potential losses, but more risk-seeking when the same decision is framed in terms of potential gains.

Overall, prospect theory provides a framework for understanding how individuals make decisions in uncertain situations, taking into account their cognitive biases, reference points, diminishing sensitivity, and the framing of choices. By recognizing these behavioral patterns, economists and policymakers can better understand and predict individuals' decision-making processes and design more effective interventions.