Myopic loss aversion, reference point, and money illusion
TL;DR: In this article, the authors used the portfolio selection model presented in He and Zhou [Manage. Sci., 2011, 57, 315,331] and the NYSE equity and US treasury bond returns for the period 1926-1990 to revisit Benartzi and Thaler's myopic loss aversion theory.
Abstract: We use the portfolio selection model presented in He and Zhou [Manage. Sci., 2011, 57, 315–331] and the NYSE equity and US treasury bond returns for the period 1926–1990 to revisit Benartzi and Thaler’s myopic loss aversion theory. Through an extensive empirical study, we find that in addition to the agent’s loss aversion and evaluation period, his reference point also has a significant effect on optimal asset allocation. We demonstrate that the agent’s optimal allocation to equities is consistent with market observation when he has reasonable values of degree of loss aversion, evaluation period and reference point. We also find that the optimal allocation to equities is sensitive to these parameters. We then examine the implications of money illusion for asset allocation. Finally, we extend the model to a dynamic setting.
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TL;DR: This paper found that the more frequently returns are evaluated, the more risk averse investors will be, which is in line with the behavioral hypothesis of "myopic loss aversion", which assumes that people are myopic in evaluating outcomes over time, and are more sensitive to losses than to gains.
Abstract: Does the period over which individuals evaluate outcomes influence their investment in risky assets? Results from this study show that the more frequently returns are evaluated, the more risk averse investors will be. The results are in line with the behavioral hypothesis of "myopic loss aversion," which assumes that people are myopic in evaluating outcomes over time, and are more sensitive to losses than to gains. The results have relevance for the equity premium puzzle, and also for the marketing strategies of fund managers. (This abstract was borrowed from another version of this item.) (This abstract was borrowed from another version of this item.) (This abstract was borrowed from another version of this item.) (This abstract was borrowed from another version of this item.) (This abstract was borrowed from another version of this item.) (This abstract was borrowed from another version of this item.) (This abstract was borrowed from another version of this item.) (This abstract was borrowed from another version of this item.) (This abstract was borrowed from another version of this item.) (This abstract was borrowed from another version of this item.) (This abstract was borrowed from another version of this item.) (This abstract was borrowed from another version of this item.) (This abstract was borrowed from another version of this item.) (This abstract was borrowed from another version of this item.) (This abstract was borrowed from another version of this item.) (This abstract was borrowed from another version of this item.) (This abstract was borrowed from another version of this item.) (This abstract was borrowed from another version of t (This abstract was borrowed from another version of this item.)
125 citations
TL;DR: A dynamic trading model with reference point adaptation and loss aversion is developed, and its semi-analytical solution has an asymmetric V-shaped form with respect to prior outcomes, and the related sensitivities are directly determined by the sensitivities of reference point shifts withrespect to the outcomes.
Abstract: We formalize the reference point adaptation process by relating it to a way people perceive prior gains and losses. We then develop a dynamic trading model with reference point adaptation and loss aversion, and derive its semi-analytical solution. The derived optimal stock holding has an asymmetric V-shaped form with respect to prior outcomes, and the related sensitivities are directly determined by the sensitivities of reference point shifts with respect to the outcomes. We also find that the effects of reference point adaptation can be used to shed light on some well documented trading patterns, e.g., house money, break even, and disposition effects.
42 citations
TL;DR: In this paper, the authors present an overview of behavioral and experimental asset pricing theory, and systematically review the evolution and current development of behavioral asset pricing modalities, and present a review of the current state of the art.
Abstract: This article presents an overview of literature on behavioural and experimental asset pricing theory. We systematically review the evolution and current development of behavioural asset pricing mod...
21 citations
TL;DR: Failing to Foresee the Updating of the Reference Point Leads to Time-Inconsistency in a dynamic setting and this paper addresses this problem.
Abstract: In a dynamic setting, decision makers update their reference point as a function of previous decision and outcomes. In “Failing to Foresee the Updating of the Reference Point Leads to Time-Inconsis...
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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
35,067 citations
27,773 citations
"Myopic loss aversion, reference poi..." refers background in this paper
...Based on these tendencies, Kahneman and Tversky (1979) proposed prospect theory (PT), which was later elaborated by Tversky and Kahneman (1992) into CPT....
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Book•
01 Jan 1944
TL;DR: Theory of games and economic behavior as mentioned in this paper is the classic work upon which modern-day game theory is based, and it has been widely used to analyze a host of real-world phenomena from arms races to optimal policy choices of presidential candidates, from vaccination policy to major league baseball salary negotiations.
Abstract: This is the classic work upon which modern-day game theory is based. What began more than sixty years ago as a modest proposal that a mathematician and an economist write a short paper together blossomed, in 1944, when Princeton University Press published "Theory of Games and Economic Behavior." In it, John von Neumann and Oskar Morgenstern conceived a groundbreaking mathematical theory of economic and social organization, based on a theory of games of strategy. Not only would this revolutionize economics, but the entirely new field of scientific inquiry it yielded--game theory--has since been widely used to analyze a host of real-world phenomena from arms races to optimal policy choices of presidential candidates, from vaccination policy to major league baseball salary negotiations. And it is today established throughout both the social sciences and a wide range of other sciences.
19,337 citations
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
"Myopic loss aversion, reference poi..." refers background or methods or result in this paper
...‡Tversky and Kahneman (1992) adopted these forms but with different curvature parameters and shape parameters for (dis)utility functions and for probability weighting functions for gains and losses....
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...Based on these tendencies, Kahneman and Tversky (1979) proposed prospect theory (PT), which was later elaborated by Tversky and Kahneman (1992) into CPT....
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...The second, α = 0.88, was estimated by Tversky and Kahneman (1992) and was also used in Benartzi and Thaler (1995)....
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...In this regard, see, for instance, Tversky and Kahneman (1992), Camerer and Ho (1994), Wu and Gonzalez (1996), Abdellaoui (2000), Bleichrodt and Pinto (2000), Abdellaoui et al. (2007), Booij and van de Kuilen (2009), and Booij et al. (2010)....
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...…for the probability weighting functions for gains and losses, respectively, and took the parameter values to be 0.61 and 0.69, also as per the estimates in Tversky and Kahneman (1992). period is a consequence of mental accounting and plays an important role in influencing investment behaviour....
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TL;DR: This paper showed that an equilibrium model which is not an Arrow-Debreu economy will be the one that simultaneously rationalizes both historically observed large average equity return and the small average risk-free return.
6,141 citations
"Myopic loss aversion, reference poi..." refers background in this paper
...Email: xh2140@columbia.edu ¶The puzzle was first articulated by Mehra and Prescott (1985), who found the historical equity premium of the S&P 500 index for the period 1889–1979 to be 6.18%, much higher than could be accounted for by a standard consumption-based utility maximization model....
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