What aspect of decision-making does prospect theory emphasize the importance of?

Prospect theory emphasizes the significance of framing and attitudes towards gains and losses as key elements in decision-making processes. It suggests that individuals evaluate potential outcomes not merely in terms of final wealth or utility, but based on perceived gains and losses relative to a reference point. This means that people tend to react differently depending on how choices are presented—whether they are framed as potential gains or losses.

For example, individuals are often more sensitive to losses than to equivalent gains, a phenomenon known as loss aversion. This can lead to behaviors that deviate from what traditional economic theory would predict, where decisions are made solely based on expected utility maximization. By highlighting how context and presentation can influence decision-making, prospect theory illustrates the complexities of human behavior in uncertain situations, making it crucial for understanding investor psychology and market dynamics.