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Journal ArticleDOI

Do financial professionals behave according to prospect theory? An experimental study

01 Jan 2013-Theory and Decision (Springer US)-Vol. 74, Iss: 3, pp 411-429
TL;DR: In this article, the authors investigated whether and to what extent this support generalizes to more naturally occurring circumstances and found that financial professionals behave according to prospect theory and violate expected utility maximization.
Abstract: Prospect theory is increasingly used to explain deviations from the traditional paradigm of rational agents. Empirical support for prospect theory comes mainly from laboratory experiments using student samples. It is obviously important to know whether and to what extent this support generalizes to more naturally occurring circumstances. This article explores this question and measures prospect theory for a sample of private bankers and fund managers. We obtained clear support for prospect theory. Our financial professionals behaved according to prospect theory and violated expected utility maximization. They were risk averse for gains and risk seeking for losses and their utility was concave for gains and (slightly) convex for losses. They were also averse to losses, but less so than commonly observed in laboratory studies and assumed in behavioral finance. A substantial minority focused on gains and largely ignored losses, behavior reminiscent of what caused the current financial crisis.

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Citations
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Journal ArticleDOI
TL;DR: In this article , the authors estimate a structural model using data from a novel experiment investigating how investors' preferred frequency of portfolio evaluations balance the opposing effects of ambiguity and loss aversion, finding that 70% of investors would opt for a high frequency of investment evaluations, reflecting the dominating effect of ambiguity aversion over loss aversion.

1 citations

01 Jan 2015
TL;DR: In this paper, the Envision rating system for sustainable infrastructure is presented to measure the influence of framing effects on engineering decision environments and the results indicate that the endowed version significantly improved students' and professional engineers' consideration for sustainability design achievement.
Abstract: Physical infrastructure (i.e. roads, pipelines, airports, dams, landfills, and water treatment systems) contributes directly to sustainability outcomes such as energy and water use and climate changing emissions. The infrastructure built today will likely impact future generations for many years. Planning, design and development decisions about infrastructure are critical to the future performance of these systems. Such decisions about infrastructure are complex with multiple variables, alternative options, and design stages. To manage decisions that exceed cognitive capacity to consider all options, decision makers often create mental shortcuts (heuristics), and accompanied errors (biases). The potential cognitive biases when dealing with complex decisions about infrastructure are examined and an approach to reframe the decision process during infrastructure planning is explored. A more critical analysis is then provided for decision aids, like energy codes and rating metrics (e.g. LEED and Envision), which are intended to reduce complexity and improve decision making using set goals and scaled points for achieving predefined objectives in sustainability. However, unintentionally, these tools may create additional biases that limit the higher achievements in sustainability that are possible. For instance, framing a decision as a loss, rather than a gain, in value can reduce the decision makers' acceptance of risk and, in turn, influence the outcome. The Envision rating system for sustainable infrastructure is presented to measure the influence of framing effects on engineering decision environments. Envision's current framework, starts users with zero points and points are achieved when design considerations move beyond conventional construction standards. In a modified version of Envision, a higher benchmark is set. Users are endowed points and can lose points for not maintaining high consideration for sustainability. Students (n=41) and professional engineers (n=65) were randomly assigned the replica Envision software or the modified version endowing points. Participants were asked to make design considerations for a redevelopment project using Envision. The results indicate, the endowed version significantly improved students' and professional engineers' consideration for sustainability design achievement. The student participants that were endowed points (n=16) scored 63 percent of possible points compared to the standard group's (n=25) 44 percent (p=0.002). The professional engineers that were endowed points (n=32) achieved 66 percent of possible points compared to the standard group's (n=33) 51 percent (p=0.002). Both students and professional engineers that were endowed points acted loss averse trying to maintain the initial points in sustainability given. These findings suggest engineers' process design decisions by comparing alternative options. And options framed as a loss or gain in value affects the decision outcome. This research underscores the advances possible at the intersection of behavioral…

1 citations

Journal ArticleDOI
TL;DR: This article found that finance professionals are more risk tolerant, more selfish, less trustworthy, and show higher levels of narcissism, psychopathy, and Machiavellianism than employees in other industries with a comparable socio-economic background.
Abstract: Since the financial crisis, the behavior and personality traits of finance professionals have come under scrutiny. As comprehensive scientific findings are lacking, we run artefactual field experiments with finance professionals and a random sample of the working population to investigate differences across industry-relevant economic preferences and personality traits. We report that finance professionals are more risk tolerant, more selfish, less trustworthy, and show higher levels of narcissism, psychopathy, and Machiavellianism. However, we find that many of these differences disappear after adjusting for socioeconomic characteristics, indicating that finance professionals are similar to employees in other industries with a comparable socio-economic background.

1 citations

Journal ArticleDOI
TL;DR: Palavras-chave et al. as discussed by the authors investigated the risk preferences in Brazil following the precepts of the Prospect Theory and found that risk preference is an important factor that influence a wide range of personal financial decisions.
Abstract: Resumo: A preferencia ao risco e um fator importante que influencia uma ampla gama de decisoes financeiras pessoais (SNELBECKER; ROSZKOWSKI; CUTLER, 1990) e e definida como a quantidade maxima de incerteza que alguem esta disposto a aceitar ao tomar uma decisao financeira ou a disposicao de se envolver em comportamentos cujos resultados sao incertos com possibilidade de se ter um resultado negativo identificavel (IRWIN, 1993). Nesse contexto, a Teoria do Prospecto surge como um modelo alternativo descritivo de escolha sob incerteza. Tendo em vista a importância crescente da influencia de aspectos comportamentais no ambiente financeiro, neste estudo buscou-se analisar as preferencias ao risco no Brasil seguindo os preceitos da Teoria do Prospecto. Para tal, por meio de questionarios de loterias (utilizadas no estudo de RIEGER; WANG; HENS, 2011), foram estimados para uma amostra de estudantes e profissionais, os parâmetros das funcoes valor (com inclusao da funcao logaritmica modificada) e peso, supondo diversas formas funcionais, para entao associar esses parâmetros a determinadas variaveis sociodemograficas. Nao foram encontrados estudos precedentes com o objetivo de realizar essa analise no Brasil, sendo que com base na literatura revisada, pode-se perceber similaridades e divergencias. A analise por genero, estado civil, faixa etaria e renda mostra relativas similaridades com outros estudos em paises desenvolvidos e em desenvolvimento. Entretanto, o nivel educacional mostra resultados contrarios ao esperado e a analise por profissao chega a resultados inconclusivos.Palavras-chave: Financas comportamentais. Teoria do Prospecto. Funcao valor. Funcao peso. Brasil. Prospect Theory: determinant factors in risk preferences in Brazil Abstract: Risk preference is an important factor that influence a wide range of personal financial decisions (SNELBECKER; ROSZKOWSKI; CUTLER, 1990) and is defined as the maximum amount of uncertainty that someone is willing to accept when making a financial decision or the disposition of to be involved in behaviors whose results are uncertain with the possibility of having an identifiable negative result (IRWIN, 1993). In this context, the Prospect Theory emerges like a descriptive alternative model of choice under uncertainty. Given the increasing importance of the influence of behavioral aspects in the financial environment, this study sought to analyze the risk preferences in Brazil following the precepts of the Prospect Theory. To this end, with lottery questionnaires (used in the study by RIEGER; WANG; HENS, 2011), were estimated for a sample of students and professionals, parameters of value (with inclusion of the modified logarithmic function) and weight functions assuming various functional forms, and then associate these parameters to certain socio-demographic variables. No previous studies were found in order to perform this analysis in Brazil, and based on the literature reviewed, we could realize some similarities and differences. Analysis by gender, marital status, age and income shows similarities with other studies in developed and developing countries. However, the educational level shows results contrary to expected and the analysis by profession comes to inconclusive results.Keywords: Behavioral finance. Prospect Theory. Value function. Weight function. Brazil.

1 citations

References
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Book ChapterDOI
TL;DR: In this paper, the authors present a critique of expected utility theory as a descriptive model of decision making under risk, and develop an alternative model, called prospect theory, in which value is assigned to gains and losses rather than to final assets and in which probabilities are replaced by decision weights.
Abstract: This paper presents a critique of expected utility theory as a descriptive model of decision making under risk, and develops an alternative model, called prospect theory. Choices among risky prospects exhibit several pervasive effects that are inconsistent with the basic tenets of utility theory. In particular, people underweight outcomes that are merely probable in comparison with outcomes that are obtained with certainty. This tendency, called the certainty effect, contributes to risk aversion in choices involving sure gains and to risk seeking in choices involving sure losses. In addition, people generally discard components that are shared by all prospects under consideration. This tendency, called the isolation effect, leads to inconsistent preferences when the same choice is presented in different forms. An alternative theory of choice is developed, in which value is assigned to gains and losses rather than to final assets and in which probabilities are replaced by decision weights. The value function is normally concave for gains, commonly convex for losses, and is generally steeper for losses than for gains. Decision weights are generally lower than the corresponding probabilities, except in the range of low prob- abilities. Overweighting of low probabilities may contribute to the attractiveness of both insurance and gambling. EXPECTED UTILITY THEORY has dominated the analysis of decision making under risk. It has been generally accepted as a normative model of rational choice (24), and widely applied as a descriptive model of economic behavior, e.g. (15, 4). Thus, it is assumed that all reasonable people would wish to obey the axioms of the theory (47, 36), and that most people actually do, most of the time. The present paper describes several classes of choice problems in which preferences systematically violate the axioms of expected utility theory. In the light of these observations we argue that utility theory, as it is commonly interpreted and applied, is not an adequate descriptive model and we propose an alternative account of choice under risk. 2. CRITIQUE

35,067 citations

Journal ArticleDOI
TL;DR: Cumulative prospect theory as discussed by the authors applies to uncertain as well as to risky prospects with any number of outcomes, and it allows different weighting functions for gains and for losses, and two principles, diminishing sensitivity and loss aversion, are invoked to explain the characteristic curvature of the value function and the weighting function.
Abstract: We develop a new version of prospect theory that employs cumulative rather than separable decision weights and extends the theory in several respects. This version, called cumulative prospect theory, applies to uncertain as well as to risky prospects with any number of outcomes, and it allows different weighting functions for gains and for losses. Two principles, diminishing sensitivity and loss aversion, are invoked to explain the characteristic curvature of the value function and the weighting functions. A review of the experimental evidence and the results of a new experiment confirm a distinctive fourfold pattern of risk attitudes: risk aversion for gains and risk seeking for losses of high probability; risk seeking for gains and risk aversion for losses of low probability. Expected utility theory reigned for several decades as the dominant normative and descriptive model of decision making under uncertainty, but it has come under serious question in recent years. There is now general agreement that the theory does not provide an adequate description of individual choice: a substantial body of evidence shows that decision makers systematically violate its basic tenets. Many alternative models have been proposed in response to this empirical challenge (for reviews, see Camerer, 1989; Fishburn, 1988; Machina, 1987). Some time ago we presented a model of choice, called prospect theory, which explained the major violations of expected utility theory in choices between risky prospects with a small number of outcomes (Kahneman and Tversky, 1979; Tversky and Kahneman, 1986). The key elements of this theory are 1) a value function that is concave for gains, convex for losses, and steeper for losses than for gains,

13,433 citations

Journal ArticleDOI
TL;DR: In this article, a menu of paired lottery choices is structured so that the crossover point to the high-risk lottery can be used to infer the degree of risk aversion, and a hybrid utility function with increasing relative and decreasing absolute risk aversion nicely replicates the data patterns over this range of payoffs from several dollars to several hundred dollars.
Abstract: A menu of paired lottery choices is structured so that the crossover point to the high-risk lottery can be used to infer the degree of risk aversion. With “normal” laboratory payoffs of several dollars, most subjects are risk averse and few are risk loving. Scaling up all payoffs by factors of twenty, fifty, and ninety makes little difference when the high payoffs are hypothetical. In contrast, subjects become sharply more risk averse when the high payoffs are actually paid in cash. A hybrid “power/expo” utility function with increasing relative and decreasing absolute risk aversion nicely replicates the data patterns over this range of payoffs from several dollars to several hundred dollars. Although risk aversion is a fundamental element in standard theories of lottery choice, asset valuation, contracts, and insurance (e.g. Daniel Bernoulli, 1738; John Pratt, 1964; Kenneth Arrow, 1965), experimental research has provided little guidance as to how risk aversion should be modeled. To date, there have been several approaches used to assess the importance and nature of risk aversion. Using lottery choice data from a field experiment, Hans Binswanger (1980) concluded that most farmers exhibit a significant amount of risk aversion that tends to increase as payoffs are increased. Alternatively, risk aversion can be inferred from bidding and pricing tasks. In auctions, overbidding relative to Nash predictions has been attributed to risk aversion by some and to noisy decision-making by others, since the payoff consequences of such overbidding tend to be small (Glenn Harrison, 1989). Vernon Smith and James Walker (1993) assess the effects of noise and decision cost by dramatically scaling up auction payoffs. They find little support for the noise hypothesis, reporting that there is an insignificant increase in overbidding in private value auctions as payoffs are scaled up by factors of 5, 10, and 20. Another way to infer risk aversion is to elicit buying and/or selling prices for simple lotteries. Steven Kachelmeier and Mohamed Shehata (1992) report a significant increase in risk aversion (or, more precisely, a decrease in risk seeking behavior) as the prize value is increased. However, they also obtain dramatically different results depending on whether the choice task involves buying or selling, since subjects tend to put a high selling price on something they “own” and a lower buying price on something they do not, which implies This is analogous to the well-known “willingness to pay/willingness to accept bias.” Asking for a high selling price 1 implies a preference for the risk inherent in the lottery, and offering a low purchase price implies an aversion to the risk in the lottery. Thus the way that the pricing task is framed can alter the implied risk attitudes in a dramatic manner. The issue is whether seemingly inconsistent estimates are due to a problem with the way risk aversion is conceptualized, or to a behavioral bias that is activated by the experimental design. We chose to avoid this possible complication by framing the decisions in terms of choices, not purchases and sales. 3 risk seeking behavior in one case and risk aversion in the other. Independent of the method used to elicit 1 a measure of risk aversion, there is widespread belief (with some theoretical support discussed below) that the degree of risk aversion needed to explain behavior in low-payoff settings would imply absurd levels of risk aversion in high-payoff settings. The upshot of this is that risk aversion effects are controversial and often ignored in the analysis of laboratory data. This general approach has not caused much concern because most theorists are used to bypassing risk aversion issues by assuming that the payoffs for a game are already measured as utilities. The nature of risk aversion (to what extent it exists, and how it depends on the size of the stake) is ultimately an empirical issue, and additional laboratory experiments can produce useful evidence that complements field observations by providing careful controls of probabilities and payoffs. However, even many of those economists who admit that risk aversion may be important have asserted that decision makers should be approximately risk neutral for the low-payoff decisions (involving several dollars) that are typically encountered in the laboratory. The implication, that low laboratory incentives may be somewhat unrealistic and therefore not useful in measuring attitudes toward “real-world” risks, is echoed by Daniel Kahneman and Amos Tversky (1979), who suggest an alternative: Experimental studies typically involve contrived gambles for small stakes, and a large number of repetitions of very similar problems. These features of laboratory gambling complicate the interpretation of the results and restrict their generality. By default, the method of hypothetical choices emerges as the simplest procedure by which a large number of theoretical questions can be investigated. The use of the method relies of the assumption that people often know how they would behave in actual situations of choice, and on the further assumption that the subjects have no special reason to disguise their true preferences. (Kahneman and Tversky, 1979, p. 265) In this paper, we directly address these issues by presenting subjects with simple choice tasks that

3,968 citations

ReportDOI
TL;DR: Mehra and Prescott as mentioned in this paper proposed a new explanation based on two behavioral concepts: investors are assumed to be "loss averse" meaning that they are distinctly more sensitive to losses than to gains.
Abstract: The equity premium puzzle refers to the empirical fact that stocks have outperformed bonds over the last century by a surprisingly large margin. We offer a new explanation based on two behavioral concepts. First, investors are assumed to be "loss averse," meaning that they are distinctly more sensitive to losses than to gains. Second, even long-term investors are assumed to evaluate their portfolios frequently. We dub this combination "myopic loss aversion." Using simulations, we find that the size of the equity premium is consistent with the previously estimated parameters of prospect theory if investors evaluate their portfolios annually. There is an enormous discrepancy between the returns on stocks and fixed income securities. Since 1926 the annual real return on stocks has been about 7 percent, while the real return on treasury bills has been less than 1 percent. As demonstrated by Mehra and Prescott [1985], the combination of a high equity premium, a low risk-free rate, and smooth consumption is difficult to explain with plausible levels of investor risk aversion. Mehra and Prescott estimate that investors would have to have coefficients of relative risk aversion in excess of 30 to explain the historical equity premium, whereas previous estimates and theoretical arguments suggest that the actual figure is close to 1.0. We are left with a pair of questions: why is the equity premium so large, or why is anyone willing to hold bonds? The answer we propose in this paper is based on two concepts from the psychology of decision-making. The first concept is loss aversion. Loss aversion refers to the tendency for individuals to be more sensitive to reductions in their levels of well-being than to increases. The concept plays a central role in Kahneman and Tversky's [1979] descriptive theory of decision-making under

2,576 citations