Showing papers on "Loss aversion published in 1995"

Myopic loss aversion and the equity premium puzzle

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

Empirical Generalizations from Reference Price Research

Abstract: Considerable theoretical justification for consumers' use of psychological reference points exists from the research literature. From a managerial perspective, one of the most important applications of this concept is reference price, an internal standard against which observed prices are compared. In this paper, we propose three empirical generalizations that are well-supported in the marketing literature. First, there is ample evidence that consumers use reference prices in making brand choices. Second, the empirical results on reference pricing also support the generalization that consumers rely on past prices as part of the reference price formation process. Third, consistent with other research on loss aversion, consumers have been found to be more sensitive to “losses,” i.e. observed prices higher than reference prices, than “gains.” We also propose topics for further research on reference prices.

Union contracts and the life-cycle/permanent-income hypothesis

Abstract: This paper isolates households in the PSID whose heads can be matched to particular long-term union contracts with high confidence. The author uses use published information on these contracts to construct a household-specific measure of expected wage growth. He finds that predictable wage movements are significantly correlated with consumption changes, contrary to neoclassical consumption theory. The author finds that consumption responds more strongly to predictable income declines than to predictable income increases. This asymmetry is inconsistent with liquidity constraints and myopia but is qualitatively consistent with models in which preferences exhibit loss aversion. Copyright 1995 by American Economic Association.

Predicting Buyer-Seller Pricing Disparities

Abstract: Numerous studies have shown that compensation demanded CD to give up a commodity often greatly exceeds willingness to pay WTP to obtain the same commodity, even in incentive compatible experiments that penalize strategic misrepresentation. Observed CD/WTP disparities are too large to be reconciled with traditional assumptions of economic rationality. A prospect theory-based behavioral framework for predicting CD and WTP is proposed which produces five distinct transaction encoding rules, any one of which can in principle apply to a buyer or a seller. According to this framework, CD/WTP gaps occur when buyers and sellers encode the prospective transaction differently, and gaps can occur in multiple ways, and vary in size, depending on encoding. The transaction encoding framework was tested in two experiments. In Experiment 1, model fits to subjects' CD and WTP for lottery tickets were consistent with the hypothesis that buyers and sellers encode transaction problems differently. Moreover, the quite large observed CD/WTP gaps were explained fully by encoding: When differences between buyers' and sellers' encoding processes were taken into account, their estimated utility value and probability weighting functions did not differ. The present framework and results show that the widely cited endowment effect is but one of several ways in which loss aversion can give rise to CD/WTP gaps. Consistent with this broadened perspective, Experiment 2 demonstrated CD/WTP gaps in the absence of an endowment effect and in the absence of rational economic causes. The transaction encoding framework 1 provides a structured approach for predicting and testing the effects of a variety of task factors on pricing behavior and transaction outcomes, and 2 reveals the useful property that, in many cases, the ratio CD/WTP can be interpreted as a direct measure of the degree of loss aversion.

Studies of Loss Aversion and Perceived Necessity

Abstract: An explanation of the loss-aversion function of prospect theory that relates the theory to a distinction between positive-based and negative-based incentive value was investigated. We predicted that betting decisions would show loss aversion to the extent that they involved necessary goals—goals that were more likely to be negatively based (associated with a threat of negative alternatives). Therefore, conditions that increased perceived goal necessity should have increased the magnitude of the loss-aversion effect. The results from 194 subjects in two studies supported this prediction. Factors related to perceived goal necessity (e.g., telic dominance, imagined proportion of financial assets to be gambled, proportion of assets in a necessities account, actual proportion of income spent on necessities) were related to reluctance to take hypothetical bets. Relationships seemed to be contingent on bet characteristics (amount and win-loss ratio). A third study suggested that these results reflected ...

Impediments to Trade in Markets for Pollution Permits

Abstract: This paper considers nine possible reasons why firms might trade less often in permit markets than was expected in the early development, and consequent simulations, of the theory. Fewer trades are bad in the sense that they lead to a potential erosion of the cost-saving properties of tradeable permit systems. The first reason considered is one which has popular currency, namely that of imperfect competition in the permit market. However, we reject this as a convincing explanation. The paper then reviews eight other possible explanations; these are oligopoly in the output market; future endowments of property rights; loss aversion; asymmetric information; non-convexities in cost functions; agency problems within the firm; transactions costs; and the sequential nature of trading.