Showing papers on "Loss aversion published in 1999"

Risk Aversion Or Myopia? Choices in Repeated Gambles and Retirement Investments

Abstract: We study how decision makers choose when faced with multiple plays of a gamble or investment. When evaluating multiple plays of a simple mixed gamble, a chance to win x or lose y, subjects show a sensitivity to the amount to lose on a single trial, holding the distribution of returns for the portfolio constant; that is, they display "myopic loss aversion." Many subjects who decline multiple plays of such a gamble will accept it when shown the resulting distribution. This analysis is applied to the problem of retirement investing. We show that workers invest more of their retirement savings in stocks if they are shown long-term (rather than one-year) rates of return.

Loss aversion in a consumption-savings model

Abstract: We propose a model of consumption and saving based on Kahneman and Tversky's Prospect Theory that implies a fundamental asymmetry in consumption behavior inconsistent with other models of consumption. When there is sufficient income uncertainty, a person resists lowering consumption in response to bad news about future income. This resistance is greater than the resistance to increasing consumption in response to good news. We present empirical evidence from five countries that confirms this behavior.

A test of competing explanations of compensation demanded

Abstract: The disparity between willingness-to-pay and willingness-to-accept, also known as compensation demanded, is a robust experimental finding. Two types of explanations been proposed. The first invokes psychological effects, broadly categorized as reference dependence and loss aversion. The second explanation is that there are large substitution effects but that underlying behavior is neoclassically utility-theoretic. The key observation motivating the present study is that loss aversion implies concavity of willingness to accept, whereas the utility-theoretic explanation implies convexity. We report experiments in which subjects were endowed with 3 items and asked the minimum payments they required to be willing to relinquish 1, 2, or 3 of them. We examine whether the compensation demanded is convex, concave, neither, or both in the number of items being relinquished.

Despairing Over Disparities: Explaining the Difference Between Willingness to Pay and Willingness to Accept

Abstract: This paper examines the three major explanations for the disparity between willingness-to-pay (WTP) and willingness-to-accept (WTA) observed in contingent value surveys and laboratory experiments: a belief that the results must be biased in some fashion, Hanemann's (1991) substitutes hypothesis, and the loss aversion model proposed by Tversky and Kahneman (1991). Starting from the assumption that individuals make utility maximizing choices, we develop structural equations that yield parametric tests of the hypotheses within a single, non-experimental framework. The approach is flexible enough to incorporate a variety of functional form and distributional assumptions and can be applied to either data from either open-ended bids or dichotomous choice questions. The usefulness of the approach is demonstrated using data from a survey that asked both WTP and WTA questions. The results provide weak support for loss aversion.

Are decisions under risk malleable

Abstract: Human decision making under risk and uncertainty may depend on individual involvement in the outcome-generating process. Expected utility theory is silent on this issue. Prospect theory in its current form offers little, if any, prediction of how or why involvement in a process should matter, although it may offer ex post interpretations of empirical findings. Well-known findings in psychology demonstrate that when subjects exercise more involvement or choice in lottery procedures, they value their lottery tickets more highly. This often is interpreted as an “illusion of control,” meaning that when subjects are more involved in a lottery, they may believe they are more likely to win, perhaps because they perceive that they have more control over the outcome. Our experimental design eliminates several possible alternative explanations for the results of previous studies in an experiment that varies the degree and type of involvement in lottery procedures. We find that in treatments with more involvement subjects on average place less rather than more value on their lottery tickets. One possible explanation for this is that involvement interacts with loss aversion by causing subjects to weigh losses more heavily than they would otherwise. One implication of our study is that involvement, either independently or in interaction with myopic loss aversion, may help explain the extreme risk aversion of bond investors.

Prospect-Theory, Mental Accounting and Differences in Aggregated and Segregated Evaluation of Lottery Portfolios

Abstract: If individuals have to evaluate a portfolio (or sequence) of lotteries their judgment is influenced by the portfolio presentation mode. Experimental studies (Redelmeier and Tversky, 1992, Benartzi and Thaler, 1998) found significantly higher acceptance rates for a sequence of lotteries, if the overall distribution was displayed instead of the set of lotteries itself. The literature provides an easy and intuitive explanation for this phenomenon based on mental accounting and loss aversion. It predicts the experimental findings to translate to all kinds of lottery types and portfolio sizes. In this paper we offer an explanation, which incorporates further evaluation concepts of Prospect Theory. Our formal analysis of the difference in aggregated and segregated portfolio evaluation demonstrates that the higher attractiveness of the aggregated presentation mode is not a general phenomenon, but depends on specific parameters of the lotteries. The theoretical findings are supported by an experimental study. In contrast to the existing evidence and in line with our theoretical results we find for specific types of lotteries an even lower acceptance rate, if the overall distribution is displayed.

A Cat Bond Premium Puzzle

Abstract: Catastrophe Bonds whose payoffs are tied to the occurrence of natural disasters offer insurers the ability to hedge event risk through the capital markets that could otherwise leave them insolvent if concentrated solely on their own balance sheets. At the same time, they offer investors a unique opportunity to enhance their portfolios with an asset that provides an attractive return that is uncorrelated with typical financial securities Despite its attractiveness, spreads in this market remain considerably higher than the spreads for comparable speculative grade debt. This paper uses results from behavior economics to suggest why cat bonds have not been more attractive to the investment community at current prices. In particular, the authors suggest that "ambiguity aversion", "loss aversion", and "uncertainty avoidance" may account for the reluctance of investment managers to invest in these products. In addition, since Catastrophe Bonds are a new type of investment, investors must invest time and money up front in order to educate themselves about the legal and technical complexities of the Cat Bond market before that investor can make a "to-buy or not-to-buy" decision. Such a transaction cost may reduce the attractiveness of the new bonds to the point where the investor would prefer to stay out of the market. The bulk of the paper consists of quantitative assessments of each of these hypotheses, along with a demonstration that Cat Bonds are indeed much more attractive than high yield bonds in terms of their Sharpe ratios (the ratio of the "excess return" over the risk free rate to the standard deviation of returns on the bonds). This is accomplished by simulating potential losses for hypothetical Cat Bonds under a wide variety of hurricane scenarios for the Miami/Dade county are. These findings lead the authors to suggest that issuers of Cat Bonds could themselves take steps to lower the cost of placing risk in this manner. Specifically, issuers might standardize a simple structure of terms to decrease the investor's cost of education. In addition issuers could better quantify and reduce pricing uncertainty. These steps will should increase demand for these instruments and produce a concomitant reduction in price.

Irrational Trading in a Financial Market

Abstract: A basic assumption in economics is that agents prefer more to less. We find that in an experimental financial market--a large scale political stock market--more than 50 percent of the traders act irrationally in the sense that they violate this fundamental assumption frequently (at least 10 percent of the time). However, the impact of this irrationality seems small, since related losses consist of less than 1 percent of total investments in this market and we find no effect on prices. We do however find systematic bias in prices: Our evidence shows that the sum of the bid prices of all traded stocks exceeds the fundamental value of the market about 10 percent of the time. We argue that another type of irrationality known as 'loss aversion' causes this upward bias.

The Status Quo Bias

Abstract: An important implication of reference dependence and loss aversion is that stability—the current state—is favored over change. Kahneman and Tversky (1984, p. 348) exemplified this by means of the story of two identical twins who find two alternative environments equally attractive. If, by a stroke of fate, the twins are separated and placed in the two environments, they will adopt their new states as reference points. Since they evaluate the advantages and disadvantages of each other’s environments on basis of their reference states, both will no longer be indifferent between the environments but will prefer to stay where fate drove them to.

Ownership structure, myopic loss aversion, and the problem of 'presentiation'

Abstract: This study examines the influence of institutional investors on firm innovation. Institutions are segmented by their cash flow preferences. Using traditional agency theory, a set of institutions is...