Explain the concept of prospect theory in the context of investment decision-making.

Prospect theory is a behavioral economic theory that seeks to explain how individuals make decisions under conditions of uncertainty, particularly in the context of investment decision-making. It was developed by psychologists Daniel Kahneman and Amos Tversky in 1979 as an alternative to the traditional rational choice theory.

According to prospect theory, individuals do not make decisions based on the expected value of outcomes alone, but rather on the perceived gains and losses relative to a reference point. This reference point is often the individual's current wealth or a certain level of expected return.

Prospect theory suggests that individuals evaluate potential gains and losses asymmetrically. Specifically, individuals tend to be risk-averse when facing potential gains and risk-seeking when facing potential losses. This means that individuals are more likely to take risks to avoid losses than to pursue gains.

Furthermore, prospect theory introduces the concept of diminishing sensitivity, which states that individuals are less sensitive to changes in wealth as they move away from the reference point. This implies that individuals are more sensitive to losses than to gains of the same magnitude.

In the context of investment decision-making, prospect theory suggests that individuals are more likely to take risks when they have experienced losses or are below their reference point. This behavior is known as the "disposition effect," where individuals tend to hold onto losing investments in the hope of recovering their losses, while quickly selling winning investments to secure gains.

Prospect theory also highlights the importance of framing and presentation of investment options. The way investment choices are presented can significantly influence decision-making. For example, individuals may be more willing to take risks if an investment is framed as a potential gain rather than a potential loss.

Overall, prospect theory provides insights into the psychological biases and heuristics that influence investment decision-making. By understanding these biases, investors and policymakers can better design investment strategies and policies that align with individuals' decision-making tendencies.