Behavioral Finance

2012/2013

Chapter 6

Prospect Theory

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Theory for decision making under risk

Normative Theory Expected Utility Theory
(von Neumann and Morgenstern, 1944)

Descriptive Theory Prospect Theory

(Kahneman and Tversky, 1979)

Objective probability judgment A set of intuitive axioms Roots to be found in Bernoulli (1738)

Explicitly not normative Positive application (summarizes what people actually do) Probably the most widely cited (influential) social science paper ever published

Advice how you should decide

Prediction of what you will decide

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Prospect Theory
Choice problem
Prospect theory is strictly defined for choice situations involving risk, although it has found its way into other disciplines as well (e.g. marketing) This is the preparation before options are evaluated. Based on perception and psychological processes, the presented information is organized.

Editing Phase

Evaluation Phase Probability weighting

Value Function

This the link between observing information and performing a choice. In contrast to expected utility theory, risk is evaluated on two different dimensions. (1) Probabilities and (2) payoffs

Decision

In contrast to normative choice theories, the goal of prospect theory is to provide good prediction of choices

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Editing Phase: Coding

In contrast to expected utility theory, decision makers do not consider their final wealth. They consider gains and losses compared to a reference point. During the editing phase, decision makers will decide what reference point to use (e.g. opportunity cost, minimum wage requirement, etc.) The payoffs of the lottery will then be coded as a gain or a loss Coding
Choice Problem Reference Point Modification

Option L 200.50
or

Option S 10
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Expected earnings in an experiment 10

Option L 100.5-10
or

Evaluation Phase

Option S 0

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Editing Phase: Combination

In the evaluation phase, as in expected utility theory, only payoffs and probabilities are considered Therefore, probabilities of events with identical outcomes are combined to one event.
Combination
Choice Problem Reduction to Payoffs and Probabilities

Option L 20E1(0.1)20E2(0.5)0
or

Option L 200.60
or

Evaluation Phase

Option S 10
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Option S 10

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Editing Phase: Simplification

People have difficulties to pick up small numerical differences in probabilities and payoffs For both, probabilities and payoffs, are modified to simpler numbers

Simplification
Choice Problem Rounding up/down to simpler numbers

Option L 210.490
or

Option L 200.50
or

Evaluation Phase

Option S 10
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Option S 10

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Editing Phase: Segregation

People perceive situations involving risk different than situations involving sure outcomes (i.e. sure payoffs are not risky payoffs with probability 1) Sure gains are segregated from the lottery, the same is true for sure losses

Segregation
Choice Problem Disentangle safe from risky payoffs

Option L 300.2510
or

Option L 10 + 200.250
or

Evaluation Phase

Option S 15
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Option S 15

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Editing Phase: Cancellation (Type I)

People focus on differences rather than similarities when evaluating prospects Equal payoffs of two options are therefore not considered when performing a choice (are considered not to have an influence on wealth)
Cancellation
Choice Problem Identical payoffs are not considered

Option L 200.250.5-5
or

Option L 00.250.5-5
or

Evaluation Phase

Option S 200.2150.5-10
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Option S 00.2150.5-10

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Editing Phase: Cancellation (Type II)

In expected utility theory we have the Reduction of Compound Lotteries axiom In prospect theory: two-stage lotteries are reduced to the reduced form If in the first stage one payoff is zero, the first stage is neglected all together
Cancellation
Two-stage Lottery 0.8 0.25 0.75 0.2 Neglecting of the first stage

20
0.8

20
00 Evaluation Phase

00
0.2

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Editing Phase
Cancellation

Note:
The sequence of editing procedures may differ between decision makers and choice problems The sequence of editing procedures probably depends on the task and framing of the choice problem The application of some editing procedures may prevent others from being applied

Coding Segregation Combination

Simplification

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Note down your decisions for the following scenario

Story: 600 people are attacked by a fatal disease Choice: Which program would you prefer Program A: Saving 200 lives for sure Program B: Saving 600 lives with 1/3 probability

S1

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Note down your decisions for the following scenario

Story: 600 people are attacked by a fatal disease Choice: Which program would you prefer Program A: Losing 400 lives for sure Program B: Losing 600 lives with 2/3 probability

S2

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Note down your decisions for the following scenario

Story: Imagine that you have just been given 1000 Euro Choice: Which option would you prefer
Option A: You receive 500 Euro for sure Option B: You receive 1000 Euro with 50% chance and nothing otherwise

S3

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Behavioral Finance

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Note down your decisions for the following scenario

Story: Imagine that you have just been given 2000 Euro Choice: Which option would you prefer
Option A: You have to pay back 500 Euro for sure Option B: You have to pay back 1000 Euro with 50% chance and nothing otherwise

S4

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Framing effect
Story: 600 people are attacked by a fatal disease Choice: Which program would you prefer Live-saving frame:
Program A: Saving 200 lives for sure Program B: Saving 600 lives with 1/3 probability

Live-losing frame:

S1 Blacked Out To be revealed in the lecture S2

Program A: Losing 400 lives for sure Program B: Losing 600 lives with 2/3 probability

Program A and B are identical in both scenarios. Only the Frame of choice tasks changes
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Framing Effect
Story: Imagine that you have just been given 1000 Euro Choice: Which option would you prefer
Option A: You receive 500 Euro for sure Option B: You receive 1000 Euro with 50% chance and nothing otherwise

S3

Story: Imagine that you have just been given 2000 Euro Choice: Which option would you prefer

Option A: You have to pay back 500 Euro for sure Option B: You have to pay back 1000 Euro with 50% chance and nothing otherwise

Blacked Out To be revealed in the lecture

S4

Option A and B are identical in both scenarios. Only the Frame of choice tasks changes
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Evaluation Phase: Value Function

Three characteristics
Decreasing marginal utility for gains (risk-aversion), identical to expected utility theory () Risk-seeking for losses () Loss-aversion, i.e. people generally reject lotteries of the form +X0.5-X ()

Does loss aversion exist in expected utility theory? Can you think of an experimental method to measure loss aversion?
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Evaluation Phase: Probability Weighting

Kahneman and Tversky, 1979 Kahneman and Tversky 1992

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Fourfold pattern of risk attitude

Payoff

risk-seeking

risk-averse

low

high Probability

risk-averse

risk-seeking

Implicit in Prospect Theory (Kahneman and Tversky, 1979)

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but not a new idea (Friedman and Savage, 1948 ) and (Markowitz, 1952)

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What are the lessons learned in Chapter 6?

Please take some time to compile a list of a few bullet points about the most important facts you took from this chapter.

Check and discuss your list with that of your neighbor

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Lessons learned: Chapter 6

There are two approaches in modeling decision making under risk
Normative (i.e. expected utility theory) Descriptive (i.e. prospect theory)

Prospect theory consists of two processes

Editing phase (psychological biases concerning the numerical information) Evaluation Phase
Value function (similar to expected utility theory) Probability function

Blacked Out To be revealed in the lecture

Implication of evaluation phase: fourfold pattern of risk preferences

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References: Chapter 6
Friedman, Milton and L. J. Savage (1948). The utility analysis of choices involving risk. Journal of Political Economy, 56 (4), 297-304. Kahneman, Daniel and Amos Tversky (1979). Prospect theory: An analysis of decision under risk. Econometrica, 47 (2), 263-292. Markowitz, Harry (1952). The utility of wealth. Journal of Political Economy, 60 (2), 151-158. Neumann, John von and Oskar Morgenstern (1944). Theory of Games and Economic Behavior. Princeton University Press: Princeton. Tversky, Amos and Daniel Kahneman (1992). Advances in prospect theory: Cumulative representation of uncertainty. Journal of Risk and Uncertainty, 5 (4), 297-323.
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