Showing papers on "Loss aversion published in 2001"

Prospect Theory and Asset Prices

Abstract: We study asset prices in an economy where investors derive direct utility not only from consumption but also from fluctuations in the value of their financial wealth. They are loss averse over these fluctuations, and the degree of loss aversion depends on their prior investment performance. We find that our framework can help explain the high mean, excess volatility, and predictability of stock returns, as well as their low correlation with consumption growth. The design of our model is influenced by prospect theory and by experimental evidence on how prior outcomes affect risky choice.

Loss Aversion and Seller Behavior: Evidence from the Housing Market

Abstract: Data from downtown Boston in the 1990s show that loss aversion determines seller behavior in the housing market. Condominium owners subject to nominal losses 1) set higher asking prices of 25-35 percent of the difference between the property's expected selling price and their original purchase price; 2) attain higher selling prices of 3-18 percent of that difference; and 3) exhibit a much lower sale hazard than other sellers. The list price results are twice as large for owner-occupants as investors, but hold for both. These findings are consistent with prospect theory and help explain the positive price-volume correlation in real estate markets.

Loss Aversion and Seller Behavior: Evidence from the Housing Market

Abstract: Data from downtown Boston in the 1990s show that loss aversion determines seller behavior in the housing market. Condominium owners subject to nominal losses 1) set higher asking prices of 25‐ 35 percent of the difference between the property’ s expected selling price and their original purchase price; 2) attain higher selling prices of 3‐ 18 percent of that difference; and 3) exhibit a much lower sale hazard than other sellers. The list price results are twice as large for owneroccupants as investors, but hold for both. These e ndings suggest that sellers are averse to realizing (nominal) losses and help explain the positive price-volume correlation in real estate markets.

Anomalies: Risk Aversion

Abstract: Economists ubiquitously employ a simple and elegant explanation for risk aversion: It derives from the concavity of the utility-of-wealth function within the expected-utility framework. We show that this explanation is not plausible in most applications, since anything more than economically negligible risk aversion over moderate stakes requires a utility-of-wealth function that is so concave that it predicts absurdly severe risk aversion over very large stakes. We present examples of how the expected-utility framework has misled economists, and why we believe a better explanation for risk aversion must incorporate loss aversion and mental accounting.

Mental Accounting, Loss Aversion, and Individual Stock Returns

Abstract: We study equilibrium firm-level stock returns in two economies: one in which investors are loss averse over the fluctuations of their stock portfolio and another in which they are loss averse over the fluctuations of individual stocks that they own Both approaches can shed light on empirical phenomena, but we find the second approach to be more successful: in that economy, the typical individual stock return has a high mean and excess volatility, and there is a large value premium in the cross-section which can, to some extent, be captured by a commonly used multifactor model

Mental Accounting, Loss Aversion, and Individual Stock Returns

Abstract: We study equilibrium firm-level stock returns in two economies: one in which investors are loss averse over the f luctuations of their stock portfolio, and another in which they are loss averse over the f luctuations of individual stocks that they own Both approaches can shed light on empirical phenomena, but we find the second approach to be more successful: In that economy, the typical individual stock return has a high mean and excess volatility, and there is a large value premium in the cross section which can, to some extent, be captured by a commonly used multifactor model OVER THE PAST TWO DECADES, researchers analyzing the structure of individual stock returns have uncovered a wide range of phenomena, both in the time series and the cross section In the time series, the returns of a typical individual stock have a high mean, are excessively volatile, and are slightly predictable using lagged variables In the cross section, there is a substantial “value” premium, in that stocks with low ratios of price to fundamentals have higher average returns, and this premium can to some extent be captured by certain empirically motivated multifactor models 1 These findings have attracted a good deal of attention from finance theorists It has proved something of a challenge, though, to explain both the time series and crosssectional effects in the context of an equilibrium model where investors maximize a clearly specified utility function In this paper, we argue that it may be possible to improve our understanding of firm-level stock returns by refining the way we model investor preferences For guidance as to what kind of refinements might be important, we turn to the experimental evidence that has been accumulated on how people choose among risky gambles Many of the studies in this literature suggest that loss aversion and narrow framing play an important

Nominal Loss Aversion, Housing Equity Constraints, and Household Mobility: Evidence from the United States

Abstract: This paper exploits the significant recent variation in U.S. house prices to empirically examine the effect on housing equity constraints and nominal loss aversion on household mobility. The analysis uses unique, detailed data from 1985-1996 on household characteristics, mobility, and wealth from the National Longitudinal Survey of Youth (NLSY79) matched with house price data from 149 metropolitan areas to estimate semi-parametric proportional hazard models of intra- and inter-metropolitan mobility. There are five principal findings. First, household intra-metropolitan own-to-own mobility responds differently to nominal housing losses than to gains. Second, nominal loss aversion is significantly less pronounced in intra-metropolitan own-to-rent and inter-metropolitan mobility, respectively. Third, there is some evidence of binding equity constraints in intra-metropolitan own-to-own mobility. Fourth, there is little evidence that low equity constrains intra-metropolitan own-to-rent and inter-metropolitan mobility, respectively. Fifth, a comparison of the estimated effects indicates that nominal loss aversion has a more dominant effect than equity constraints in restricting household mobility: roughly two-and-a-half to three times the impact of equity constraints.

Loss Aversion and Seller Behaviour: Evidence from the Housing Market

Abstract: Data from downtown Boston in the 1990s show that loss aversion determines seller behaviour in the housing market. Condominium owners subject to nominal losses: (1) set higher asking prices of 25-35% of the difference between the property's expected selling price and their original purchase price; (2) attain higher selling prices of 3-18% of that difference; and (3) exhibit a much lower sale hazard than other sellers. The list price results are twice as large for owner-occupants as for investors, but hold for both. These findings are consistent with prospect theory and help explain the positive price-volume correlation in real estate markets.

Loss Aversion and Seller Behavior: Evidence from the Housing Market

Abstract: Data from downtown Boston in the 1990s show that loss aversion determines seller behavior in the housing market. Condominium owners subject to nominal losses 1) set higher asking prices of 25-35 percent of the difference between the property's expected selling price and their original purchase price; 2) attain higher selling prices of 3-18 percent of that difference; and 3) exhibit a much lower sale hazard than other sellers. The list price results are twice as large for owner-occupants as investors, but hold for both. These findings are consistent with prospect theory and help explain the positive price-volume correlation in real estate markets.

Mental Accounting, Loss Aversion, and Individual Stock Returns

Abstract: We study equilibrium firm-level stock returns in two economies: one in which investors are loss averse over the fluctuations of their stock portfolio and another in which they are loss averse over the fluctuations of individual stocks that they own. Both approaches can shed light on empirical phenomena, but we find the second approach to be more successful: in that economy, the typical individual stock return has a high mean and excess volatility, and there is a large value premium in the cross-section which can, to some extent, be captured by a commonly used multifactor model.

Cumulative Prospect Theory for Parametric and Multiattribute Utilities

Abstract: Different attitudes towards gains and losses are a prominent feature of cumulative prospect theory for decision under uncertainty. In particular, decision weights for uncertain events can depend on whether the events involve gains or losses, and the shape of the utility function can reveal loss aversion. Decision analyses concentrate on event capacities, which determine decision weights, and on the shape of the utility function. The present paper focuses on linear/exponential, power-function and multilinear utility models for decision under uncertainty. We begin with straightforward preference axioms for a representation by a cumulative prospect theory functional. The axioms include weak ordering, continuity, monotonicity and tail independence. We show that in their presence constant absolute proportional risk aversion implies linear/exponential power utility. Then, for the multiattribute case, mutual utility independence leads to a utility function that is additive/multiplicative multilinear.

Probability Weighting in Choice under Risk: An Empirical Test

Abstract: This paper reports a violation of rank-dependent utility with inverse S-shaped probability weighting for binary gambles. The paper starts with a violation of expected utility theory: one-stage gambles elicit systematically different utilities than theoretically equivalent two-stage gambles. This systematic disparity does not disappear, but becomes more pronounced after correction for inverse S-shaped probability weighting. The data are also inconsistent with configural weight theory and Machina's fanning out hypothesis. Possible explanations for the data are loss aversion and anchoring and insufficient adjustment.

Attitudes of UK managers to risk and uncertainty

Abstract: The authors provide an overview of their research into the attitudes of UK managers to risk and uncertainty. They find that, when it comes to decision making, managers in UK enterprises tend to focus on loss aversion rather than risk aversion. They found that managers’ personal attitudes to risk were often more important than risk management systems and their appropriateness.

The asset allocation decision in a loss aversion world

Abstract: The purpose of this paper is to derive explicit formulae for the asset allocation decision for the loss aversion utility function proposed by Kahneman and Tuversky. We show that these utility functions exhibit constant absolute risk aversion. We also give analytic results which interpret the assumptions of risk-aversion with respect to gains but risk-a!ection with respect to losses in terms of changes of the optimal investment of equity when the probability that equity outperforms cash goes up. For the Knight, Satchell and Tran (1995) family of distributions, it is straightforward to derive closed form expressions for the optimal portfolio weights in all cases. Using UK and US data, we confirmed that the values of the parameters in the loss aversion function suggested by many previous studies are compatible with the observed proportions held in equity in both the UK and the US. The distributional assumptions are not innocuous. However, whilst modelling upside and downside returns by gamma distributions leads to plausible results, modelling upside and downside by truncated normals does not.

A Note on Loss Aversion and Futures Hedging

Abstract: This note examines the effect of loss aversion on the futures trading behavior of a short hedger. Using a modified constant-absolute-risk-aversion utility function, I show that loss aversion has no effect in an unbiased futures market. It has different, predictable impacts when the futures market is in backwardation or contango. © 2001 John Wiley & Sons, Inc. Jrl Fut Mark 21: 681–692, 2001

Systems and method for online investing

Abstract: A method of managing indexed investment products via a computer network includes the step of generating a set of portfolios, each portfolio composed of weighted classes of assets and associated with a degree of loss aversion. The set of portfolios are stored in a database. A set of return distributions are generated for each portfolio for selected investment options and horizon dates and stored in a database. A selected portfolio is matched with an online investor in response to degree of loss aversion information input from the online investor. The online investor is then provided a return distribution associated with the selected portfolio in response to investment option and horizon date information input from the online investor.

The Endowment Effect, Status Quo Bias and Loss Aversion: Rational Alternative Explanation

Abstract: The endowment effect, status quo bias, and loss aversion are robust and well documented results from experimental psychology. They introduce a wedge between the prices at which one is willing to sell or buy a good. The objective of this paper is to address this wedge. We show that the presence of asymmetric information in a rational-agent framework can account for the endowment effect, status quo bias and loss aversion as well as psychology-based explanations proposed in the past.

Opportunism in Capital Budget Recommendations: The Effects of Past Performance and Its Attributions*

Abstract: This study uses an experiment to examine the separate and combined effects of managers' loss aversion and their causal attributions about their divisions' performance on tendencies to make goal-incongruent capital budget recommendations. We find that managers' recommendations are biased by their loss aversion. In particular, managers of high-performing divisions are more likely than managers of low-performing divisions to propose investments that maximize their division's short-term profits at the expense of the firm's long-term value. We also find that managers' recommendations are biased by their causal attributions. In particular, managers are more likely to propose investments that maximize their division's short-term profits at the expense of the firm's long-term value when they attribute their division's performance to external causes (e.g., task difficulty or luck) rather than to internal causes (e.g., managerial ability or effort). Further, the effects of causal attributions are greater for managers of high-performing divisions than for managers of low-performing divisions. The study's findings are important because loss aversion and causal attributions are often manifested in firms. Thus, they may bias managers' decisions, which in turn may be detrimental to the firms' long-term value.

How Monetary Policy Can Have Permanent Real Effects with Only Temporary Nominal Rigidity

Abstract: A macroeconomic model is developed in which the psychological concept of loss aversion is incorporated into workers' preferences. The impact of monetary, policy in the presence of loss aversion depends on the specification of the reference wage. The plausible specification that a worker's reference wage is the real wage she was paid in the previous period is considered in detail. Specifying the reference wage in this way, we show that an unanticipated change in monetary policy has a permanent, real effect when short term labour contracts are written in nominal wages.

Decision Research: Behavioral

Abstract: This article describes current trends and controversies in behavioral decision research. Much of the empirical research in this field has focused on violations of rational choice theory. Some violations are utility-based, such as loss aversion, framing effects, and contextual effects. Others are belief-based, such as base rate neglect and conjunction errors. This abundance of evidence has led behavioral decision researchers to develop descriptive theories based on more realistic assumptions about human nature. Issues such as fairness, self-control, emotional satisfaction, social pressure, and cultural norms are directly incorporated into the choice process. This approach to theorizing is gradually gaining popularity in other areas of social science, such as behavioral economics, behavioral finance, behavioral game theory, and behavioral accounts of the law.

Die Psychologie begrenzt rationaler Wirtschaftspolitik: Das Beispiel des Reformstaus

Abstract: Mainstream economists are reluctant to integrate features of bounded rationality into their behavioural assumptions. However, particularly in the field of economic policy the scope for limited rationality is given, since voters lack incentives for rational reasoning concerning their voting decision. The explanatory power of limited rationality is demonstrated for the example of reform resistance. Status quo preferences, endowment effects and loss aversion are typical deviations from full rationality and explain resistance against beneficial reforms even if there is full information and no uncertainty. From this psychological perspective, a major precondition for the implementation of reforms is the loss of status quo as an available option. Test runs of policy options may also be helpful for overcoming psychological reform resistance.

Decision Biases, Cognitive Psychology of

Abstract: Normative analyses of rational decision making dictate how decisions ought to be made. Descriptive analyses of decision making are based on experimental studies and emphasize the role of information processing in people's decisions. The empirical evidence indicates that people's decisions are often at odds with the assumptions of the rational theory. Some of the cognitive mechanisms that underlie decision behavior and cause it to depart from the normative benchmark, yielding systematic decision biases, are described. Normative theory assumes preferences to be clear and stable. Consequently, they are expected to be invariant across normatively equivalent assessment methods (‘procedure invariance’), and across logically equivalent ways of describing the options (‘description invariance’). Instead, preferences appear to be formed, not merely revealed, during their elicitation, and their formation appears to depend, among other things, on how the options are described and on the methods through which preference is elicited. Because people tend to be risk-averse when choosing between gains, and risk seeking when choosing between losses, alternative descriptions of what is essentially the same decision problem can give rise to predictably different choices. This failure of description invariance is known as a ‘framing effect.’ People are also loss averse, which refers to the fact that losses loom larger than corresponding gains. Loss aversion entails a strong tendency to maintain the status quo and a reluctance to make fair trades, which can hinder negotiations. Another important cognitive principle is the principle of compatibility, according to which the weight of a stimulus attribute is enhanced to the extent that it is compatible with the required response. Alternative methods of eliciting preference can thus lead to differential weighings of attributes and, consequently, to different choices, contrary to procedure invariance. In further violation of invariance, independent vs. comparative evaluation procedures also tend to highlight different aspects of options and can thus alter decision. These decision biases, among others, have been observed in numerous settings. Because they emerge from underlying cognitive mechanisms, they form an inherent part of the ways in which we process information and make decisions.

Loss Aversion and Seller Behaviour: Evidence from the Housing Market

Abstract: Data from downtown Boston in the 1990s show that loss aversion determines seller behaviour in the housing market. Condominium owners subject to nominal losses: (1) set higher asking prices of 25-35% of the difference between the property’s expected selling price and their original purchase price; (2) attain higher selling prices of 3-18% of that difference; and (3) exhibit a much lower sale hazard than other sellers. The list price results are twice as large for owner-occupants as for investors, but hold for both. These findings are consistent with prospect theory and help explain the positive price-volume correlation in real estate markets.

Nominal Loss Aversion, Housing Equity Constraints, and Household Mobility: Evidence from the United States

Abstract: This paper exploits the significant recent variation in United States house prices to empirically examine the effect on housing equity constraints and nominal loss aversion on household mobility. The analysis uses unique, detailed data from 1985-1996 on household characteristics, mobility, and wealth from the National Longitudinal Survey of Youth (NLSY79) matched with house price data from 149 metropolitan areas to estimate semiparametric proportional hazard models of intra- and inter-metropolitan mobility. There are five principal findings: (1) household intra-metropolitan own-to-own mobility responds differently to nominal housing losses than to gains; (2) nominal loss aversion is significantly less pronounced in intra-metropolitan own-to-rent and inter-metropolitan mobility, respectively; (3) there is some evidence of binding equity constraints in intra-metropolitan own-to-own mobility; (4) there is little evidence that low equity constrains intra-metropolitan own-to-rent and inter-metropolitan mobility, respectively; (5) a comparison of the estimated effects indicates that nominal loss aversion has a more dominant effect than equity constraints in restricting household mobility, roughly two and one-half to three times the impact of equity constraints.

On the theory of reference-dependent preferences (revised)

Abstract: A theory is proposed in which preferences are conditional on reference points It is related to Tversky and Kahneman's reference-dependent preference theory, but is simpler and deviates less from conventional consumer theory Preferences conditional on any given reference point satisfy standard assumptions Apart from a continuity condition, the only additional restriction is to rule out cycles of pairwise choice The theory is consistent with observations of status quo bias and related effects Reference points are treated as subject to change during the course of trade The implications of endogeneity of reference points for behaviour in markets are investigated

The endowment effect, status quo bias and loss aversion : rational alternative explanation

Abstract: The endowment effect, status quo bias, and loss aversion are robust and well documented results from experimental psychology. They introduce a wedge between the prices at which one is willing to sell or buy a good. The objective of this paper is to address this wedge. We show that the presence of asymmetric information in a rational-agent framework can also account for the endowment effect, status quo bias and loss aversion without invoking psychology-based explanations proposed in the past.