What key principle does prospect theory center on?

Prospect theory, developed by Daniel Kahneman and Amos Tversky, emphasizes that individuals' decisions are influenced significantly by how choices are framed and evaluated, particularly in situations involving risk and uncertainty. The theory posits that people perceive potential gains and losses differently, leading to behaviors that deviate from expected utility theory, which assumes rational decision-making.

One of the fundamental aspects of prospect theory is the concept of loss aversion, where losses weigh heavier on individuals than equivalent gains. This explains why people's reactions to potential losses can determine their risk preferences and decision-making processes. For instance, how a scenario is presented (framed) can greatly impact whether an individual opts for a risky gamble or a certain outcome. This notion underscores the importance of psychological factors in economic behavior, contrasting with traditional views that decisions are based solely on wealth or rational calculations.

The other options do not encapsulate the core principle of prospect theory as effectively. For example, the idea that risk-taking is primarily based on wealth fails to consider the psychological biases that influence decisions. Similarly, claiming that investors are inherently risk-seeking overlooks the nuance of loss aversion and how individuals actually process gains and losses. Lastly, the assertion that all decisions are made rationally directly contradicts the