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Chapter 6. Human Behavior > Prospect Theory

Prospect Theory

Investment bubbles have always been a part of market history. For example, speculators in the Netherlands in the 17th century drove up the prices of tulip bulbs to absurd levels. The inevitable crash followed. Since then, from the Great Depression to the recent dot-com implosion, people can’t seem to steer clear from speculative manias. They make the same mistakes over and over again.

Daniel Kahneman, the Princeton professor who was the first psychologist to win the Nobel Prize in Economics, for studies he conducted with Amos Tversky, attributed market manias partly to investors’ “illusion of control,” calling the illusion “prospect theory.” Kahneman studied the intellectual underpinnings of investing—how traders estimate odds and calculate risks—in order to prove how often we act from the mistaken belief that we know more than we do. Kahneman’s stark conclusion is that we are victims of our own overconfidence.


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