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Q1Domain Verified
In the context of Prospect Theory, which of the following BEST describes the concept of "reference dependence"?
Investors solely focus on the absolute value of their wealth when making investment decisions.
Investment decisions are primarily influenced by the perceived gains and losses relative to a subjective reference point, rather than absolute wealth.
The reference point is a fixed, objective market benchmark that all investors universally adopt.
Investors are indifferent to whether an outcome is a gain or a loss as long as the absolute magnitude is the same.
Q2Domain Verified
The "reflection effect" in Prospect Theory suggests that investors' attitudes towards risk are reversed when moving from potential gains to potential losses. Which of the following scenarios BEST illustrates this effect?
An investor who is risk-seeking when facing a sure gain of $100 versus a gamble with a 50% chance of $200 and a 50% chance of $0, becomes risk-averse when facing a sure loss of $100 versus a gamble with a 50% chance of losing $200 and a 50% chance of losing $0.
An investor who is risk-averse when facing a sure gain of $100 versus a gamble with a 50% chance of $200 and a 50% chance of $0, becomes risk-seeking when facing a sure loss of $100 versus a gamble with a 50% chance of losing $200 and a 50% chance of losing $0.
An investor always prefers gambles over sure outcomes, irrespective of whether they are gains or losses.
An investor consistently exhibits risk-averse behavior across both gains and losses, regardless of the probabilities.
Q3Domain Verified
A key concept in Prospect Theory is the "probability weighting function." How does this function typically deviate from objective probabilities, and what is its implication for investor behavior?
It underweights low probabilities and overweights high probabilities, causing investors to dismiss significant risks and be overly cautious about highly probable outcomes.
It overweights low probabilities and underweights high probabilities, leading to a tendency to ignore rare but potentially catastrophic events and chase unlikely but highly rewarding opportunities.
It primarily distorts probabilities closer to the certainty threshold, leading to a disproportionate fear of almost certain losses.
It linearly scales objective probabilities, meaning investors perceive risks precisely as they are objectively measured.

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