Advanced Financial Modelling - Essay Example

For that reason, people, tend to base their decisions on certain perceived elements of gains rather than elements of perceived losses (Back, 2010, pg. 208). In essence, if a person is presented with two equal choices to make, he or she will express one choice in terms of the possible losses and the other choice in term of the possible gains. For that reason, the person will choose the choice with possible gains (Kaustia, 2010, pg. 25). An example can be used to demonstrate the prospect theory as it applies to financial decision making.

Two different financial advisors present the same mutual fund to an investor. The first financial advisor tells the investor that the average return of the mutual fund is 7%. The second financial advisor mentions that the mutual fund has realized above average return for the past 15 years but the last 5 years have shown a decline. According to the prospect theory, the investor will choose a mutual fund from the first financial advisor. This is because it is not expressed in a combination of returns and losses as did the second financial advisor (Li and Yan, 2010, pg. 101). The prospect theory was proposed and developed in 1979 by two aristocrats, Amos Tversky and Daniel Kahneman.

The theory emerged as a psychologically description of the financial decision making process (Ma, 2011, pg. 428). The theory also makes a comparison to the expected utility theory. According to prospect theory, editing and evaluation are the two central stages that every financial decision making process must pass through. The outcomes of a decision are made and ordered during the editing stage. During this stage, people consider lesser outcomes as losses and greater outcomes as gains. The aim of this stage is to alleviate any possible framing effects (Barberis and Xiong, 2012, pg. 99). In addition, it helps in resolving the isolation effects that stem out from the propensity to isolate concurrent