Do financial professionals behave according to prospect theory? An experimental study
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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TL;DR: In this article, the impact of prior investment experience on price efficiency in asset markets was analyzed and it was shown that both positive and negative experience gained in the investment game lead to efficient pricing in both market settings.
Abstract: We run laboratory experiments to analyze the impact of prior investment experience on price efficiency in asset markets. Before subjects enter the asset market they gain either no, positive, or negative investment experience in an investment game. To get a comprehensive picture about the role of experience we implement two asset market designs. One is prone to inefficient pricing, exhibiting bubble and crash patterns, while the other exhibits efficient pricing. We find that (i) both, positive and negative, experience gained in the investment game lead to efficient pricing in both market settings. Further, we show that (ii) the experience effect dominates potential effects triggered by positive and negative sentiment generated by the investment game. We conjecture that experiencing changing price paths in the investment game can create a higher sensibility on changing fundamentals (through higher salience) among subjects in the subsequently run asset market.
16 citations
TL;DR: In this article, the authors investigate professionals' risk taking behavior under social competition when investing for others, and find that professionals increase their risk taking for others when they lag behind other professionals.
Abstract: Two aspects of social context are central to the finance industry. First, financial professionals usually make investment decisions on behalf of third parties. Second, social competition, in the form of performance rankings, is pervasive. Therefore, we investigate professionals’ risk taking behavior under social competition when investing for others. We run online and lab-in-the-field experiments with 805 financial professionals and show that professionals increase their risk taking for others when they lag behind. Additional survey evidence from 1349 respondents reveals that professionals’ preferences for high rankings are significantly stronger than those of the general population.
15 citations
TL;DR: In this paper, the authors demonstrate that investors pay explicit attention to the probability of losing, additionally to being loss averse, and that participants' willingness to take risks is heavily influenced by loss probabilities, and performance feedback is unable to mitigate this effect.
Abstract: In a series of experiments we demonstrate that investors pay explicit attention to the probability of losing, additionally to being loss averse. Participants’ willingness to take risks is heavily influenced by loss probabilities, and performance feedback is unable to mitigate this effect. This behavior contradicts predictions of normative and descriptive decision theories such as Expected Utility Theory and (Cumulative) Prospect Theory. Our experimental design allows us to rule out alternative explanations and enables a comparison of decisions under risk and ambiguity while analyzing the importance of the probability of losing for financial decisions.
12 citations
TL;DR: In this article, the authors report tests of reflection over money and health outcomes defined by life years gained from treatment, with open valuation exercises, the results suggest qualified support for the reflection effect over money outcomes and strong support over health outcomes.
Abstract: Prospect theory is the most influential descriptive alternative to the orthodox model of rational choice under risk and uncertainty, in terms of empirical analyses of some of its principal parameters and as a consideration in behavioural public policy. Yet the most distinctive implication of the theory—a fourfold predicted pattern of risk attitudes called the reflection effect—has been infrequently studied and with mixed results over money outcomes, and has never been completely tested over health outcomes. This article reports tests of reflection over money and health outcomes defined by life years gained from treatment. With open valuation exercises, the results suggest qualified support for the reflection effect over money outcomes and strong support over health outcomes. However, in pairwise choice questions, reflection was substantially ameliorated over life years, remaining significant only for treatments that offered short additional durations of life.
10 citations
TL;DR: In this article, the authors present a heterogeneous agents model of the foreign exchange market in which agents' risk attitudes vary over time due to psychological factors emphasized in prospect theory, and find that psychological component and risk-profit elasticity play significant roles in exchange rate expectations formation and investment behavior.
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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
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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,
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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
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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