Violations at the Reference Point of Discontinuity: Limitations of Prospect Theory and an Alternative Model of Risk Choices

The tilted S-shaped utility function proposed in Prospect Theory (PT) relied fundamentally on the geometrical notion that there is a discontinuity between gains and losses, and that individual preferences change relative to a reference point. This results in PT having three distinct parameters; concavity, convexity and the reference point represented as a disjoint between the concavity and convexity sections of the curve. The objective of this paper is to examine the geometrical violations of PT at the zero point of reference. This qualitative study adopted a theoretical review of PT and Markowitz’s triply inflected value function concept to unravel methodological assumptions which were not fully addressed by either PT or cumulative PT. Our findings suggest a need to account for continuity and to resolve this violation of PT at the reference point. In so doing, an alternative preference transition theory, was proposed as a solution that includes a phase change space to cojoin these three separate parameters into one continuous nonlinear model. This novel conceptual model adds new knowledge of risk and uncertainty in decision making. Through a better understanding of an individual’s reference point in decision making behaviour, we add to contemporary debate by complementing empirical studies and harmonizing research in this field.