PROSPECT THEORY

BACK TO RISK: WHAT HAVE WE SEEN SO FAR

Individuals do not always behave consistently with EUT
 Violations of independence axiom (Allais paradox)
 Violations of transitivity
 Inability to compose lotteries and role of frames

Is there a way to reconcile the existing empirical evidence with a model of

economic behavior?

Starting point: observation of empirical evidence

A SIMPLE TASK
Problem 1
I addition to whatever you own, you have been given 1000 €. You are now asked
to choose between

A: (1000, .50; 0, .50) and B: (500, 1.)

Problem 2
In addition to whatever you own, you have been given 2000€. You are now asked
to choose between

C: (-1000, .50; 0, .50) and D: (-500, 1.)

A SIMPLE TASK – EMPIRICAL EVIDENCE
Problem 1
I addition to whatever you own, you have been given 1000 €. You are now asked
to choose between

A: (1000, .50; 0, .50) and B: (500, 1.)

(16%) (84%) (N=70)
Problem 2
In addition to whatever you own, you have been given 2000€. You are now asked
to choose between

C: (-1000, .50; 0, .50) and D: (-500, 1.)

(69%) (31%) (N=68)
A SIMPLE TASK – LESSONS LEARNT
 Reversal in risk preferences
 Choose risky lottery when one could gain something
 Choose safe choice when one could lose something
 Individuals react differently to gains and losses!

 Lotteries A and C are equivalent in terms of final states, and so are B and D
 A=C= (2000, .50; 1000, .50) and B=D= (1500, 1.)

 Individuals do not seem to compose lotteries!

GAINS AND LOSSES (K&T 1981)
Decision (i) Choose between
A. a sure gain of $240
B. 25% chance to gain $1000 and 75% chance to gain nothing

Decision (ii) Choose between

C. a sure loss of $750
D. 75% chance to lose $1000 and 25% chance to lose nothing

Results (N=150)
A:84% B:16% Reversal of risk attitudes
C:13% D:87%
No composition and
A&D 25% chance to win $240 and 75% chance to lose $760 violation of stochastic
B&C 25% chance to win $250 and 75% chance to lose $750 dominance
LEARNING FROM EXPERIMENTAL DATA
Can we infer something about the function that underlies the preferences that
emerge from experimental data?
Choice 1
A. (6000, 0.25; 0, 0.75) 18% N=68
B. (4000, 0.25; 2000, 0.25; 0, 0.5) 82%
Choice 2
C. (-6000, 0.25; 0, 0.75) 70% N=64
D. (-4000, 0.25; -2000, 0.25; 0, 0.5) 30%
Patterns of preference imply
Choice 1
0.25v(6000)<0.25[v(4000)+v(2000)] -> v(6000)<v(4000)+v(2000)
Choice2
0.25v(-6000)>0.25[v(-4000)+v(-2000)] -> v(-6000)>v(-4000)+v(-2000)
 V(x)
GAINS

LOSSES

Choice 1 – domain of GAINS

v(6000)<v(4000)+v(2000) -> CONCAVITY -> RISK AVERSION
Choice2 – domain of LOSSES
v(-6000)>v(-4000)+v(-2000) -> CONVEXITY -> LOVE FOR RISK

But how to determine what is a loss and what is a gain?

Is it dependent just on current state of wealth?
 PANDEMIC FLU - 1
Imagine the U.S. is preparing for the outbreak of an unusual Asian disease,
which is expected to kill 600 people. Two alternative programs to combat
the disease have been proposed. Assume that the exact scientific estimates of
the consequences of the program are as follows :

If program A is adopted, 200 people will be saved.

If program B is adopted, there is 1/3 probability that 600 people will be
saved, and 2/3 probability that no people will be saved.

Which program would you choose?

PANDEMIC FLU - 2
Imagine the U.S. is preparing for the outbreak of an unusual Asian disease,
which is expected to kill 600 people. Two alternative programs to combat
the disease have been proposed. Assume that the exact scientific estimates of
the consequences of the program are as follows :

If program A is adopted, 400 people will die.

If program B is adopted, there is 1/3 probability that nobody will die, and
2/3 probability that 600 people will die.

Which program would you choose?

 FRAMES MATTER!
 Experimental results
Option A Option B
Flu 1 - survival 72% 28%
Flu 2- mortality 22% 78%

 BUT: the two situations are exactly the same!

 If program A is adopted, 200 people will be saved = If program A is adopted, 400 people
will die.
 If program B is adopted, there is 1/3 probability that 600 people will be saved, and
2/3 probability that no people will be saved = If program B is adopted, there is 1/3
probability that nobody will die, and 2/3 probability that 600 people will die.

 It seems like gains are losses are defined using reference points that are
arbitrarily dependent on the frames used
 This violates description invariance!
DO WE WEIGHT PROBABILITIES?
Generally individuals are risk averse in the domain of gains and risk lovers in the
domain of losses,
This pattern is reversed when small probabilities are involved
 weighting small probabilities

Example
Option 1 Option 2
Case 1 (5000, .001) (5, 1) Love for risk
72% 28%
Case 2 (-5000, .001) (-5,1) Risk aversion

17% 83%

The reversal in risk attitudes may be interpreted as overweighting of small

probabilities
 SUMMARY
Evidence presented so far shows
Reversal of risk patterns between gains and losses
 Risk averse for gains
 Risk loving for losses
Importance of the reference point to determine what is a gain and
what is a loss
 Role of frames
Reversal of risk patterns for small probabilities
 Risk averse for losses
 Risk loving for gains
 Implies some probability weighting is at play!
PROSPECT THEORY (KAHNEMAN AND TVERSKY 1979)
A model of choice under uncertainty with decision weights

Simple prospects of the form (x,p; y,q) with at most two non-zero outcomes

Two components:
1.a value function v assigning to each outcome x a subjective value v(x)
2.a weighting function π associating each probability p with a decision
weight π(p)
PROSPECT THEORY (CONTINUED)
Two phases:
1. framing/editing. Determines the reference point (neutral reference outcome,
value=0). Transforms strictly positive (negative) lotteries.
2. evaluation: the value function, decision weights and outcomes are expressed as
deviations (gains and losses) from the reference point.

In phase 2 outcomes X, expressed wrt reference point are evaluated following a

subjective value function v(x) which is:
• defined on gains and losses
• concave for gains and convex for losses:

v"(x) < 0 for x > 0

v"(x) > 0 for x < 0
ARE GAINS AND LOSSES SYMMETRIC?
V(x)
GAINS

V(z)

LOSSES

V(- z)
Loss aversion -> value function
steeper for losses than for gains
LOSS AVERSION IN THE «REAL WORLD»

“Now that I've won a slam, I know something

very few people on earth are permitted to
know. A win doesn't feel as good as a loss feels
bad, and the good feeling doesn't last long as
the bad. Not even close.”

― Andre Agassi, Open

EVOLUTIONARY ORIGIN OF LOSS AVERSION
Santos and Rosati (2005): capuchin monkeys tend to choose the risky
alternative over the safe one when the apple pieces at stake are reduced
(domain of losses), but do the reverse when have to choose between a risky
and a certain increase in apple slices.
Martino et al. 2006: there are specific areas of the brain that activate in
respose to frames:
1. the amygdala, which is in generally involved in the detection of
emotionally relevant cues,
2. and the orbitomedial prefrontal cortex (OMPFC), responsible for
mitigating impulsiveneness in decision-making. Individuals that have
brain lesions in the OMPFC show impaired ability in decision-making,
becoming impulsive
THE DECISION WEIGHT FUNCTION

A function π (p) relating decision weights π to probabilities p.

π (p) increasing function of p with π (0)=0 and π (1)=1

Properties of π
overweighting of small probabilities
for small p: π(p)>p

Can we say something more about the properties of this function?

INTRODUCING PROBABILITY WEIGHTS (1/2)
Case 1
A: (2500$, .33; 2400 $, .66; 0, 0$.01)
B: (2400$, 1)

Case 2
C: (2500 $, .33; 0 $, .67)
D: (2400$, .34, 0$, .66)

Preference pattern: B  A and C  D

Let us figure out how decision weights work!

 INTRODUCING PROBABILITY WEIGHTS (2/2)
Preference pattern: B  A and C  D
Let us write the preference relation in a modified EU-like form,
combining probabilities, outcomes and using also probability
weights π
 assigned to all p
 not necessarily=p

BA v(B)>v(A) v(2400)>π(.66)v(2400)+ π (.33)v(2500)

[1- π (.66)v(2400)> π (.33)v(2500)

CD v(C)>v(D) π (.33)v(2500)> π (.34)v(2400)

SUBCERTAINTY
B  A v(B)>v(A) πv(B)>πv(A)
v(2400) > π(.66)v(2400)+ π (.33)v(2500)
[1- π (.66)v(2400) > π (.33)v(2500)

C  D v(C)>v(D) πv(C)>πv(C)
π (.33)v(2500) > π (.34)v(2400)
1-π(.66) > π(.34)

π(.66)+ π(.34)<1

Subcertainty: complementary probabilities do not imply

complementary weights!
ALLAIS’ COMMON RATIO PROBLEM REVISITED

Choose between
A. a sure gain of $30 78%
B. 80% chance to win $45 and 20% chance to win 0 22%

Choose between
C. 25% chance to win $30 and 75% chance to win 0 42%
D. 20% chance to win $45 and 80% chance to win 0 58%

Reversal of risk profiles in the domain of gains and losses

SUBPROPORTIONALITY
A  B πv(A)> π v(A)
π(1) v(30)> π(0.8) v(45) + π(0.2) v (0)
π(1) v(30)> π(0.8) v(45)
v(30)  (0.8)
 (1)
v(45)  (1)
DC πv(D)> π v(C)
π(0.2) v(45) + π(0.8) v (0) > π(0.25) v(30) + π(0.75) v (0)
π(0.2) v(45) > π(0.25) v(30)
 (0.2) v(30) (2)

 (0.25) v(45)
Combining (1) and (2) yields

 (0.2) v(30)  (0.8)  (0.2)  (0.8)

  
 (0.25) v(45)  (1)  (0.25)  (1)
SUBPROPORTIONALITY

What does subproportionality imply?

 (0.2)  (0.8)

 (0.25)  (1)
The probability ratios are the same BUT the ratio of weights is not!

Weights decrease as probabilities increase!

 SUMMARY: THE DECISION WEIGHT FUNCTION
A function π (p) relating decision weights π to probabilities p.
π (p) increasing function of p with π (0)=0 and π (1)=1

Properties of π
overweighting of small probabilities
for small p: π(p)>p

subcertainty
for all 0<p<1: π(p)+ π(1-p)≤1

Thus, low probabilities are overweighted, moderate and high probabilities are underweighted,
and the latter effect is stronger than the former

subproportionality
π(pr)/π(p) < π(pqr)/π(pq)for all 0<p,q,r≤1
 PROSPECT THEORY AND RISK ATTITUDES
PT relies on subjective evaluations that are influences by framing effects

PT accomodates a fourfold pattern of risk attitudes featuring loss aversion

p small p medium/large
gains risk seeking risk averse
losses risk averse risk seeking

Besides experimental evidence on column 1 (p small) can you thing of real-life

examples where such risk patterns apply?
 07/02/

CUMULATIVE PROSPECT THEORY

•Cumulative Prospect theory (Tversky, Kahneman 1992) provides a

framework able to accomodate for
– Framing effects
– Nonlinear preferences
– Source dependence
– Love for risk
– Loss aversion
– Does not assume that the weighting function is a monotone transformation of outcome
probabilities -> the explicitly formulated a weighting function!
 PT VS CUMULATIVE PT
Both accomodate for risk aversion and risk seeking behavior
Cumulative PT accounts for losses to loom larger than gains
 Utility function in the domain of losses is steeper than in the domain of gains

This difference induces diminishing sensitivity

 The impact of a given change in probability is larger the closer we are to the boundaries
 The weighting function is concave near 0 and convex near 1
WEIGHTING FUNCTION IN CUMULATIVE PT
Certainty effect: certain
outcomes are overweighted
compared to probable ones

Subproportionality:
weights decrease as
probabilities increase

Overweighting Subcertainty: complementary

of small probabilities do not imply
probabilities complementary weights
BACK TO MM TRIANGLE
Experimental evidence shows
• curves are not straight
• departures from linearity are more prononunced near the edges of the triangle
• strict fanning out can be rejected
• curves are concave in the upper part of the triangle and convex in the lower right
• curves for gains and losses reflect
CPT FUNCTIONAL FORM
 Value function should have a concave trait and a convex trait:
 Two-part power function

𝑧𝛼 0 < 𝛼 < 1 𝑖𝑓 𝑧 ≥ 0
𝑣 𝑧 =൝ 𝛽
−𝜆 −𝑧 𝜆 > 1, 0 < 𝛽 < 1 𝑖𝑓 𝑧 < 0
 K&T estimated 𝛼 = 0.88 and 𝜆 = 2.25

 Decision weight should feature the properties we discussed

 K&T estimated 𝛾 = 0.61 and 𝜒 = 0.69

A FINAL NOTE ON ALTERNATIVES TO EUT
Prospect theory is not the only competing model of decision-making under
uncertainty, although it is certainly the most popular
Alternative theories can be grouped into two broad groups:
1. Conventional theories – they retain the axiomatic structure with
mimmun modifications (in general relax independence axiom)
2. Non-conventional theories – they make no assumptions on respect of
axiomatic properties – CPT is the most famous of these theories!
IMPLICATIONS OF PT-RELATED
CONCEPTS
REFERENCE POINT
Outcomes are defined with respect to a reference point, that becomes the zero in
the value scale.
The psychological concept of reference point is related to the fact that in the body,
some systems have an optimal set point. The body works to maintain this point and,
after any deviation, try to restore it.
Relevant reference point could be:
• Current wealth
• Expected wealth

Example
𝒓 = (300, 0.6; 700, 0.4 )
When the reference point is the expected wealth: 460
𝒓 = (−160, 0.6; 240, 0.4 )
DIFFERENT EXPECTATIONS
Example: an individual will be disappointed when he expects a
prize of 10 but then receives a prize of only 5.
What this expectation depends upon may be:
previous experience
status of others

Example of social comparison: an individual could be happy when

receives a prize of 5, but he could be disappointed when discovers
that his friends received a prize of 10
Adaptation to new reference point may have unexpected
consequences: the happiness threadmill
IMPLICATIONS OF LOSS AVERSION
•Reference point is defined by the individual in
different ways
• What happens when reference point is ownership?
A SIMPLE CLASSROOM EXPERIMENT
• You probably all noticed the stands of the recent Department Open
day. They were handing out different gadgets to prospective
students :
• A highlighter
• A set of headphones

Now imagine that I handed out to you one of these items.

How many of those who received the headphones would be willing to
exchange it with the highlighter? What about the opposite trade?

What is a reasonable theoretical expectation?

ANOTHER SIMPLE CLASSROOM EXPERIMENT
•Imagine you were asked to state how much you are willing to pay
for nice water bottle with the CF logo on it.
• How much would you pay?

•Now assume I am giving you one of these bottles. How much money
would you want to sell the water bottle?
• How much would you ask?

• Students like you all over the world consistently exhibit a willingness
to pay (WTP) much lower than their willingness to sell (WTA)!
ENDOWMENT EFFECT
•Pricing items you already own is different than simple pricing
• Endowment effect: discovered by environmental economists
Hammack and Brown (1974)
• duck hunters would pay $247 each to maintain a wetland suitable for ducks…
• but asked $1044 to give up the wetland
• willingness To Pay ≠ Willingness To Accept

• Owning affects reference points, giving up what you own is

affected by loss aversion
•A lot of experimental evidence supporting this effect with very different
designs
GOING BACK TO THE WATER BOTTLE EXAMPLE
Recall we said WTP>WTA?
Can we think of reasons for which this could be true that has nothing to do with
loss aversion?

We might just not want the water bottle – ‘’acquisition’’ aversion

How can we check which aversion is really at play?
Kahneman, Knetsch and Tahaler (1990) divided the students into three groups:
buyers choosers and sellers.
Choosers simply indicates whether they preferred getting the mug or getting the
money for a series of monetary values. The indifference value of choosers was
3.12$ on average, very close to the buyers’ average evaluation (2.87$) and very
far from the sellers’s one ($7.12)
DIMENSIONS AFFECTING THE ENDOWMENT
EFFECT
Endowment effect is substantially robust across different setups:
 Actual substituability between goods
 Value evaluability
 Nature of the good (hedonic or functional)
 Hypothetical or real transactions
ANOTHER IMPLICATION OF PT: MULTIPLE
LOTTERIES
• Recall we said earlier that people do not seem to
compose lotteries!
• What happens when individuals play several lotteries in sequence?

• PT suggests that people may integrate position or

segregate them:
• If you segregate no matter what the previous bet resulted into, you always go
back to the reference point – use PT value function as normal
• If you integrate you may end up taking up too much risk.

• Examples of integration:
• Break even effect
• House money effect
MENTAL ACCOUNTING
A SIMPLE PROBLEM
You are going to see a play tonight. The ticket costs 10€ and you really
want to see it.
Just outside the theater, you pull out your wallet to purchase your ticket
and notice that you have lost a 10€ bill.
Do you buy the ticket?
A SIMPLE PROBLEM - REVISITED
You are going to see a play tonight. The ticket costs 10€ and you wanted
to see it so much that you have already purchased the ticket.
Just outside the theater, you check your pockets, but the ticket is lost and
there is no way to recover it .
Do you buy another ticket?
A SIMPLE PROBLEM – A RATIONALE
In both cases, you lost 10€
In both cases you need to decide whether the theater experience is worth
another 10€
This further 10€ may take the form of a ticket or the form of cash –
technically it should be irrelevant!
Yet, most people would buy the ticket in the first case but not in the second
one!
MENTAL ACCOUNTING
‘The set of cognitive operations used by individual and households to organize,
evaluate and keep track of financial activities’ (Thaler, 2000)
Key components:
 Account assignment
 Account closure
 Account evaluation

Crucial aspect: different accounts are managed separately!

Assignment: It is a way to mentally divide your money according to different

reasons/objectives
Closing and evaluation: each account may have a different pattern
MA hedonically efficient: postpone feeling losses and frequently evaluate gains

Integration vs segregation
SUNK COSTS AND MENTAL ACCOUNTING
The effect of integrating sunk costs does not linger indefinitely.
Suppose you buy a pair of shoes. They feel perfectly comfortable in the
store, but the first day you wear them they hurt. A few days later you try
them again, but they hurt even more than the first time.
Thaler (2000) predicts that
(1) The more you paid for the shoes, the more times you will try to wear
them.
(2) Eventually you stop wearing the shoes, but you do not throw them
away. The more you paid for the shoes, the longer they sit in the back of
your closet before you throw them away.
(3) At some point, you throw the shoes away, regardless of what they cost,
the payment having been fully 'depreciated'.
IMPLICATIONS OF MENTAL ACCOUNTING
Budgeting and self-control problems but careful of unintended
consequences
Portfolio management across different accounts may become complicated
Credit cards and spending
 COMBINING REFERENCE
DEPENDENCE, LOSS AVERSION AND Empirical evidence of the
disposition effect

MENTAL ACCOUNTING
THE DISPOSITION EFFECT
Tendency to hold on to losing stocks for too long while selling superior-
perfroming stocks too early.
Investors realize their gains more readily than their losses!
(Shefrin and Statman 1985)
ODEAN AND SELLING WINNERS
Data
 Records of 10,000 accounts with a discount brokerage house during 1987-
1993.
At each day at which a sale is made:
 Compare the current price with average purchase price (gains & losses) Each
stock in the portfolio not sold that day is a paper loss or paper gain

Hypothesis testing
 H.1 disposition to sell winners : PGR>PLR
 H.2 tax-awareness in december: (PLR-PGR)Dec>(PLR-PGR)Jan-Nov
where
Proportion of Gains Realized (PGR)=Realized Gains/(Realized
Gains+Paper Gains)
Proportion of Losses Realized (PLR)=Realized Losses/(Realized
Losses+Paper Losses)
RESULTS
Individuals tend to significantly sell winners over losers
 Even in December, although less so
Result consistent with similar laboratory experiments
 Ex. Weber and Camerer 1995

Entire Year December Jan.-Nov.

PLR 0.098 0.128 0.094

PGR 0.148 0.108 0.152

Difference in proportions -0.050 *** 0.020 *** -0.058 ***

A ‘RATIONAL’ BENCHMARK
What would a traditionally rational behaviour look like in this case?
• Gains are taxed,
• Losses can be used to offset gains & ordinary income (up to $3,000).
• Implication: other things being equal, sell losing stocks before winning stocks.
PT AND THE TENDENCY TO SELL WINNERS
Can PT explain empirical evidence of tendency to sell winners?
• gains -> risk aversion

Following gains, losses are scarier than gains are attractive -> Sell!
• losses-> risk taking

Losses make us want to get even -> Keep!

Moreover, individuals consider separately different assets (Mental accounting)

• Reference point= purchase price
• closing a “mental account” in losing position creates psychological pain, even if losses can
be used to reduce taxes (tax-swap)
POSSIBLE ALTERNATIVE EXPLANATIONS
Transaction costs? No, same effect for different price groups
Belief in regression to the mean? If so, clearly wrong
 losers get lower performance than winners after next 84,252,504
trading days!

Belief on mean reversion should apply to stocks that an

investors does not already own, as well as those one does.
 But investors buy new stocks that outperform the average index over the
past two years -> inconsistent with belief on mean reversion!

Loss aversion is the only reasonable explanation!

 REFERENCES
oA&D – Chapter 3

oKahneman, Daniel & Amos Tversky, "Prospect theory," Econometrica

1979, 47(2), 263-91
o Martino, Benedetto De, Dharshan Kumaran, Ben Seymour, and
Raymond J Dolan. 2006. “Frames, Biases, and Rational Decision-Making
in the Human Brain.” Science 313 (5787): 684–87.
doi:10.1126/science.1128356.Frames.
o Santos, Laurie, and Alexandra Rosati. 2015. “The Evolutionary Roots
of Human Decision Making.” Annual Review of Psychology 33 (4): 395–
401. doi:10.1038/nbt.3121.ChIP-nexus.
Shefrin, Statman (1985) The Disposition to Sell Winners Too Early and Ride
Losers Too Long: Theory and Evidence, The Journal of finance
o Tversky, Amos and Daniel Kahneman (2000). Choices, Values, and Frames.
Cambridge University Press.