Prospect Theory: Curvilinear Relationship

Prospect Theory

Curvilinear Relationship.

Kahneman and Tversky’s prospect theory explanations found that a curvilinear relationship between risk and return.  Accordance to  Kahneman and Tversky’s , risk attitudes are not determined by the level of the outcome,  but by the outcome relation to reference point. The main reason of reference point is to central to prospect theory explanations.  In the prospect theory suggests that people outweigh outcome that are probable with outcomes with the certain. As we all know, people like to get gains to likely gains and prefer losses to likely losses. Many researches assumes that a reference point is compare between industry average or seen by the performance of referent other firms.

The concept of prospect theory is to see managers adopt the both risk seeking and risk averse, based on whether manager consider themselves to be in the domain of gain or losses. From present research, choices by individual or group in organizations facing their problem or firm level differences in risk behavior is a strategy and organizational use to prospect theory.  Prospect theory suggest to manager adopt risk seeking behavior when their expected outcomes from actions are below their reference point  while when the performance is upper on target level, they are risk averse. From research, I can concluded that the target level as the median return of the firm’s in the industry. In the chapter the risk and return relationship, we found that these predictions mean that in a group of firm’s with above target returns, risk and return should be positive outcomes while the below target returns, risk and return would be negatively outcomes.

Prospect theory explains how the manager may exhibit the difference types of risky behavior that are assuming by relative performance or others feedback. In Prospect Theory have a many strategy scholars have used to justify their hypotheses but their apply in substantially different contexts than those considered in the development of the theory. Scholars strategy have elaborate Kahneman and Tversky’s as predicting risk taking by individual and organizations with low result relative to a reference point. Also, their avoid high performance by individual and organization with high result relative to a reference point. (c.f. Bowman 1980, 1982, 1984 Fiegenbaum and Thomas 1986, 19888; Fiegenbaum  1990, Jeggers 1991).

In the decision making, prospect theory assuming that there would ignoring their wealth in evaluating gambles. This decision give an impact of firm’s performance on risk taking . Besides that, examining  gambles in isolation implies would choices will involve positive and negative outcomes, it which makes the effect of Prospect Theory for mixed gambles critical. Prospect Theory’s value function predicts almost risk neutrality far from the reference point when the firm’s seeing a choice with all positively or all negatively outcomes instead of risk aversion or seeking. To have a positive association between risk and return for firms below the reference point requires less than risk seeking for lower performances than higher performances ones, and vice versa above the reference point.