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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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TL;DR: This article found that both rankings and tournament incentives increase risk-taking among underperforming professionals, but not among students, and that rank-driven risk taking is robust to various experimental settings, including private identity priming and framing, and related to preferences for relative per-formance.
Abstract: Rankings are pervasive in the finance industry, yet there is no research how they impact financial professionals? behavior. We run lab-in-the-field experiments with 657 profession- als, lab experiments with 432 students and collect survey evidence from 1,349 respondents to investigate how rank incentives affect investment decisions. We find that both rankings and tournament incentives increase risk-taking among underperforming professionals, but not among students. Rank-driven risk-taking is robust to various experimental settings, including private identity priming and framing, and related to preferences for relative per- formance, which we find to be stronger for professionals than for the general population and other competitive professions.

59 citations

Journal ArticleDOI
TL;DR: In this article, the effect of key audit matters (KAM) in the auditor's report as required by the new ISA 701 is investigated, considering investment professionals and non-professional investors.
Abstract: We investigate the effect of key audit matters (KAM) in the auditor’s report as required by the new ISA 701. We consider investment professionals and non-professional investors in our experiments, ...

47 citations

Journal ArticleDOI
15 Oct 2014-PLOS ONE
TL;DR: In this paper, a large-scale empirical analysis of 28.5 million trades made by 81.3 thousand traders of an online financial trading community over 28 months was conducted to explore the large scale empirical aspect of prospect theory.
Abstract: Prospect theory is widely viewed as the best available descriptive model of how people evaluate risk in experimental settings. According to prospect theory, people are typically risk-averse with respect to gains and risk-seeking with respect to losses, known as the “reflection effect”. People are much more sensitive to losses than to gains of the same magnitude, a phenomenon called “loss aversion”. Despite of the fact that prospect theory has been well developed in behavioral economics at the theoretical level, there exist very few large-scale empirical studies and most of the previous studies have been undertaken with micro-panel data. Here we analyze over 28.5 million trades made by 81.3 thousand traders of an online financial trading community over 28 months, aiming to explore the large-scale empirical aspect of prospect theory. By analyzing and comparing the behavior of winning and losing trades and traders, we find clear evidence of the reflection effect and the loss aversion phenomenon, which are essential in prospect theory. This work hence demonstrates an unprecedented large-scale empirical evidence of prospect theory, which has immediate implication in financial trading, e.g., developing new trading strategies by minimizing the impact of the reflection effect and the loss aversion phenomenon. Moreover, we introduce three novel behavioral metrics to differentiate winning and losing traders based on their historical trading behavior. This offers us potential opportunities to augment online social trading where traders are allowed to watch and follow the trading activities of others, by predicting potential winners based on their historical trading behavior.

41 citations

Journal ArticleDOI
TL;DR: To measure framing effects in engineering decisions, the Envision rating system for sustainable infrastructure is used, which aims to help the authors better understand how choice structures influence engineering decisions.
Abstract: Decision aids, ranging from rating systems to design software to regulatory standards, guide the design and evaluation of infrastructure projects. To present the information in these decision aids, there must first be some options such as, attributes are or are not presented, and, just as in other domains, these factors are likely to influence decisions in infrastructure development. The authors of this paper seek to better understand how choice structures influence engineering decisions. Prospect theory, which is well established in the behavioral sciences, asserts that people tend to think of possible outcomes relative to their starting point, not the resulting end point. For instance, framing a decision outcome as a loss in value (rather than a gain) can reduce the decision makers’ acceptance of risk and, in turn, lead to more conservative outcomes. To measure framing effects in engineering decisions, this paper uses the Envision rating system for sustainable infrastructure, which aims to help ...

36 citations

Journal ArticleDOI
TL;DR: The task of automatically predicting human decision-making and its use in designing intelligent human-aware automated computer systems of varying natures is explored—from purely conflicting interaction settings to fully cooperative interaction settings.
Abstract: Human decision-making often transcends our formal models of "rationality." Designing intelligent agents that interact proficiently with people necessitates the modeling of human behavior and the prediction of their decisions. In this book, we explore the task of automatically predicting human decision-making and its use in designing intelligent human-aware automated computer systems of varying natures—from purely conflicting interaction settings (e.g., security and games) to fully cooperative interaction settings (e.g., autonomous driving and personal robotic assistants). We explore the techniques, algorithms, and empirical methodologies for meeting the challenges that arise from the above tasks and illustrate major benefits from the use of these computational solutions in real-world application domains such as security, negotiations, argumentative interactions, voting systems, autonomous driving, and games. The book presents both the traditional and classical methods as well as the most recent a...

35 citations

References
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Journal ArticleDOI
TL;DR: In this paper, the authors present new experimental results that directly address the realness of such data, and their reliability as a basis for criticizing expected utility theory and promoting alternative theories.
Abstract: Much of the evidence raising doubts about expected utility theory (EUT) comes from experiments involving hypothetical decisions. Most of the rest of the evidence comes from experiments where respondents are asked to make a large number of decisions, knowing that only one of these will provide the basis for payment. Concerns have often been expressed about the "realness" of such data, and their reliability as a basis for criticizing EUT and promoting alternative theories. The present article reviews this debate and reports new experimental results that directly address this issue.

182 citations

Journal ArticleDOI
TL;DR: In this paper, a cardinal utility index for risky choices under risk is derived from introspective strength-of-preference judgments, and the cardinal index also agrees well with the choiceless utilities.

173 citations

Posted Content
TL;DR: The authors showed that risk-seeking behavior is observed in many people and appears in markets as predicted, and that market behavior is consistent with answers to hypothetical questionnaires, contrary to prospect theory, risk seeking seems to diminish with experience.
Abstract: Exchange economies were created in which individuals faced losses. If people are risk seeking in the losses, as predicted by prospect theory, then due to the nonconvexity, the competitive equilibria are all on the boundaries of the Edgeworth box. The experimental results are that risk-seeking behavior is observed in many people and appears in markets as predicted. In addition, market behavior is consistent with answers to hypothetical questionnaires. Contrary to prospect theory, risk seeking seems to diminish with experience: preferences in the market setting are not labile; and risk-seeking preferences are not simply a result of framing effects. Copyright 1997 by American Economic Association.

123 citations

Journal ArticleDOI
TL;DR: In this article, Tversky et al. tested cumulative prospect theory (CPT) in the financial market, using US stock option data, and found that the shape of the estimated functions are closer to linearity and loss aversion is less pronounced.
Abstract: The presented research tests cumulative prospect theory (CPT, [Kahneman, D., Tversky, A., 1979. Prospect theory: An analysis of decision under risk. Econometrica 47, 263–291; Tversky, A., Kahneman, D., 1981. The framing of decisions and the psychology of choice. Science 211, 453–480]) in the financial market, using US stock option data. Option prices possess information about actual investors’ preferences in such a way that an exploitation of conventional option analysis, along with theoretical relationships, makes it possible to elicit investor preferences. The option data in this study serve for estimating the two essential elements of the CPT, namely, the value function and the probability weighting function. The main part of the work focuses on the functions’ simultaneous estimation under CPT original parametric specification. The shape of the estimated functions is found to be in line with theory. Comparing to results of laboratory experiments, the estimated functions are closer to linearity and loss aversion is less pronounced.

84 citations

Journal ArticleDOI
TL;DR: In this article, the performance of three families of models (expected utility, rank-dependent expected utility, and cumulative prospect theory) using information from financial asset markets is evaluated using empirical data.
Abstract: To date, the plausibility of theories of choice under risk hinges are mainly on experimental evidence. This paper devises and implements an approach amenable of assessing the performance of three families of models (expected utility, rank-dependent expected utility, and the cumulative prospect theory) using information from financial asset markets . Our findings unequivocally support reference-point dependence, diminishing marginal sensitivity, loss aversion, and nonlinear weighting of (gain and loss) physical probabilities. The empirical observations are found to be robust to, inter alia, the parameterization of the utility and probability weighting functions, “day-of-the-week effects”, the choice of a reference point, and the introduction of possible, low-probability market crashes (peso component).

69 citations