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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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Book ChapterDOI
01 Jan 2019
TL;DR: There is evidence in the finance, corporate governance and international economics literatures that the structure, powers and dynamics of Boards of Directors and the legal structure of corporations can have substantial effects on Enterprise Risk, Group Decisions, International capital flows and trade, risk-premia, perceived risk of companies, compliance with environmental regulations and Climate Finance as discussed by the authors.
Abstract: There is evidence in the finance, corporate governance and international economics literatures that the structure, powers and dynamics of Boards of Directors and the legal structure of corporations can have substantial effects on Enterprise Risk, Group Decisions, International capital flows and trade, risk-premia, perceived risk of companies, compliance with environmental regulations and Climate Finance.

10 citations

Book ChapterDOI
31 Mar 2015
TL;DR: Using the model of individual novelty management, and the empirical statistical nature of investors’ inclination to information, the social network information flow dynamics is derived and it is shown that the “spread” of people’s position along the inverted U-shape of efficient information management leads to an unstable and inefficient macro-scale dynamics of the network's performance.
Abstract: Individuals can manage and process novel information only to some degree. Hence, when performing a perceptual novel task there is a balance between too little information (i.e. not getting enough to finish the task), and too much information (i.e. a processing constraint). Combining these new findings to a formal mathematical description of efficiency of novel information processing results in an inverted U-shape, wherein too little information is not effective to solving a problem, yet too much information is also detrimental as it requires more processing power than available. However, in an information flooded economic environment, it has been shown that humans are rather poor at managing information overload, which results in far from optimal performance. In this work we speculate that this is due to the fact that they are actually trying to maximize the wrong thing, e.g. maximizing monetary gains, while completely disregarding information management principles that underlie their decision-making. Thus, in a social decision-making environment, when information flows from one individual to another, people may “misuse” the abundance of information they receive. Using the model of individual novelty management, and the empirical statistical nature of investors’ inclination to information, we have derived the social network information flow dynamics and have shown that the “spread” of people’s position along the inverted U-shape of efficient information management leads to an unstable and inefficient macro-scale dynamics of the network’s performance. This was in turn validated through a global inverted U-shape, observed in the macro-scale network performance.

10 citations

Journal ArticleDOI
TL;DR: In this paper, the authors investigate whether the domain effect is also present among experienced employees in the finance industry and compare their decisions with people from the general population, and they find that professionals are even more reluctant to sell loser stocks than nonprofessionals.

9 citations

Journal ArticleDOI
TL;DR: In this article, the functional forms of the value and probability weighting functions commonly used for the experimental validation of prospect theory were estimated from laboratory experiments and compared to real-life betting markets.

8 citations

Journal ArticleDOI
TL;DR: In this paper, a business simulation game that replicates the basic decision-making processes of a bank granting credit to clients under conditions of risk and uncertainty was designed and implemented to measure participants' overconfidence and risk profile according to prospect theory and then conduct an experimental implementation of the simulation game.
Abstract: Behavioral biases may influence bank decisions when granting credit to their customers. This paper explores this possibility in an experimental setting, contributing to the literature in two ways. First, we designed a business simulation game that replicates the basic decision-making processes of a bank granting credit to clients under conditions of risk and uncertainty. Second, we implemented a series of short tests to measure participants’ overconfidence and risk profile according to prospect theory and then conduct an experimental implementation of the simulation game. We find that higher levels of overprecision and risk seeking for gains (mostly attributable to distortion of probabilities) foster lower prices and higher volumes of credit, and reduce quality. The most consistent result is that distortion of probabilities affects the ability to discriminate between the quality of borrowers according to objective information, fostering strategies of lower loan prices to lower quality clients. The external validity of the results is also discussed.

8 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