Showing papers on "Loss aversion published in 2006"

A Model of Reference-Dependent Preferences

Abstract: We develop a model of reference-dependent preferences and loss aversion where “gain‐loss utility” is derived from standard “consumption utility” and the reference point is determined endogenously by the economic environment. We assume that a person’s reference point is her rational expectations held in the recent past about outcomes, which are determined in a personal equilibrium by the requirement that they must be consistent with optimal behavior given expectations. In deterministic environments, choices maximize consumption utility, but gain‐loss utility influences behavior when there is uncertainty. Applying the model to consumer behavior, we show that willingness to pay for a good is increasing in the expected probability of purchase and in the expected prices conditional on purchase. In within-day labor-supply decisions, a worker is less likely to continue work if income earned thus far is unexpectedly high, but more likely to show up as well as continue work if expected income is high.

How Basic Are Behavioral Biases? Evidence from Capuchin Monkey Trading Behavior

Abstract: Behavioral economics has demonstrated systematic decision‐making biases in both lab and field data. Do these biases extend across contexts, cultures, or even species? We investigate this question by introducing fiat currency and trade to a colony of capuchin monkeys and recovering their preferences over a range of goods and gambles. We show that capuchins react rationally to both price and wealth shocks but display several hallmark biases when faced with gambles, including reference dependence and loss aversion. Given our capuchins’ inexperience with money and trade, these results suggest that loss aversion extends beyond humans and may be innate rather than learned.

Loss Aversion Is an Affective Forecasting Error

Abstract: Loss aversion occurs because people expect losses to have greater hedonic impact than gains of equal magnitude. In two studies, people predicted that losses in a gambling task would have greater hedonic impact than would gains of equal magnitude, but when people actually gambled, losses did not have as much of an emotional impact as they predicted. People overestimated the hedonic impact of losses because they underestimated their tendency to rationalize losses and overestimated their tendency to dwell on losses. The asymmetrical impact of losses and gains was thus more a property of affective forecasts than a property of affective experience.

Modeling the Psychology of Consumer and Firm Behavior with Behavioral Economics

Abstract: Marketing is an applied science that tries to explain and influence how firms and consumers behave in markets. Marketing models are usually applications of standard economic theories, which rely on strong assumptions of rationality of consumers and firms. Behavioral economics explores the implications of the limits of rationality, with the goal of making economic theories more plausible by explaining and predicting behavior more accurately while maintaining formal power. This article reviews six behavioral economics models that are useful to marketing. Three models generalize standard preference structures to allow for sensitivity to reference points and loss aversion, social preferences toward outcomes of others, and preference for instant gratification. The other three models generalize the concept of game-theoretic equilibrium, allowing decision makers to make mistakes, encounter limits on the depth of strategic thinking, and equilibrate by learning from feedback. The authors also discuss a sp...

Why Do People Pay Taxes? Prospect Theory VersusExpected Utility Theory

Abstract: Using actual probabilities of audit and penalty rates, the return on evasion is 91-98%. So why do not most of us evade? Existing analysis, based on expected utility theory (EUT) is unable to explain this. Furthermore, and contrary to intuition and the bulk of evidence, EUT predicts that evasion should be decreasing in the tax rate (Yitzhaki puzzle).We apply Tversky and Kahneman's [Tversky, A., Kahneman, D., 1992. Advances in prospect theory: cumulative representation of uncertainty. Journal of Risk and Uncertainty 5, 297-323] cumulative prospect theory to tax evasion. We show that prospect theory provides a much more satisfactory account of tax evasion including an explanation of the Yitzhaki puzzle. This also provides independent confirmation of prospect theory.

Exchange Asymmetries Incorrectly Interpreted as Evidence of Endowment Effect Theory and Prospect Theory

Abstract: Systematic asymmetries in exchange behavior have been widely interpreted as support for endowment effect theory, an application of prospect theory positing that loss aversion associated with ownership explains observed exchange asymmetries. We offer an alternative explanation. Specifically, we conjecture that observed asymmetries can be explained by procedure-driven theories grounded in classical preference theory. To test this alternative explanation, we alter the procedures to preserve the predictions of endowment effect theory while ruling out procedure-driven explanations grounded in classical preference theory. The data reject endowment effect theory in favor of procedure-driven theories.

Downside Loss Aversion and Portfolio Management

Abstract: Downside loss-averse preferences have seen a resurgence in the portfolio management literature. This is due to the increasing use of derivatives in managing equity portfolios and the increased use of quantitative techniques for bond portfolio management. We employ the lower partial moment as a risk measure for downside loss aversion and compare mean-variance (M-V) and mean-lower partial moment (M-LPM) optimal portfolios under nonnormal asset return distributions. When asset returns are nearly normally distributed, there is little difference between the optimal M-V and M-LPM portfolios. When asset returns are nonnormal with large left tails, we document significant differences in M-V and M-LPM optimal portfolios. This observation is consistent with industry usage of M-V theory for equity portfolios but not for fixed-income portfolios.

The Effect of Reference Point on Stochastic Network Equilibrium

Abstract: Following studies of human decision making under risk and uncertainty, an extensive evidence of loss aversion and asymmetric risk-taking behavior around a reference point was found. Prospect theory proposes an alternative framework to the traditional risk-taking modeling in travel behavior, which might be too simplistic. This paper examines the possibility of applying prospect theory for modeling stochastic network equilibrium, and presents an investigation of the effect of reference point value on such equilibrium. Conceptual and methodological issues that could be addressed by further research in transportation research are suggested.

Free at last? Social dominance, loss aversion, and White and Black Americans' differing assessments of racial progress.

Abstract: White Americans tend to believe that there has been greater progress toward racial equality than do Black Americans. The authors explain this difference by combining insights from prospect theory and social dominance theory. According to prospect theory, changes seem greater when framed as losses rather than gains. Social dominance theory predicts that White Americans tend to view increases in equality as losses, whereas Black Americans view them as gains. In Studies 1 and 2, the authors experimentally tested whether groups judge the same change differently depending on whether it represents a loss or gain. In Studies 3-6, the authors used experimental methods to test whether White participants who frame equality-promoting changes as losses perceive greater progress toward racial equality. The authors discuss theoretical and political implications for progress toward a just society.

A psychological law of inertia and the illusion of loss aversion

Abstract: The principle of loss aversion is thought to explain a wide range of anomalous phenomena involving tradeoffs between losses and gains. In this article, I show that the anomalies loss aversion was introduced to explain — the risky bet premium, the endowment effect, and the status-quo bias — are characterized not only by a loss/gain tradeoff, but by a tradeoff between the status-quo and change; and, that a propensity towards the status-quo in the latter tradeoff is sufficient to explain these phenomena. Moreover, I show that two basic psychological principles — (1) that motives drive behavior; and (2) that preferences tend to be fuzzy and ill-defined — imply the existence of a robust and fundamental propensity of this sort. Thus, a loss aversion principle is rendered superfluous to an account of the phenomena it was introduced to explain.

Exploring the nature of loss aversion

Abstract: Loss aversion, the fact that losses have a greater impact than gains, is a fundamental property of behavioral accounts of choice. In this paper, we suggest four possible characterizations of the relative impact of losses and gains: (1) It could be a constant, such as the much cited value of 2, as in losses have twice the impact of gains. (2) It could be a systematic individual difference, with some individuals more or less loss aversion, (3) it could be a property of the attribute, or (4) a property of the different processes used to construct selling and buying prices. We examine the behavior of a large sample of auto buyers using an experiment which allows us to measure loss aversion, at the individual level for several different attributes. A set of hierarchical linear models shows that to understand loss aversion, one must consider the process used to construct prices. Interestingly, we show that knowledge of the attribute lowers loss aversion and that age and attribute importance increases loss aversion.

The Moderating Effect of Relationship Norm Salience on Consumers' Loss Aversion

Abstract: People are said to be loss averse when their pain of losing something exceeds their joy of gaining it. This research proposes and tests a new moderator of loss aversion: the type of relationship norms salient at the time the loss or the gain is experienced. We suggest that mere salience of the norms of a communal relationship (based on concern for the partner) relative to those of an exchange relationship (based on quid pro quo) leads to a greater degree of loss aversion. A typical endowment effect study supports our overall thesis and shows that differences across relationship norms are stronger in selling prices (willingness to accept) than in buying prices (willingness to pay).

Stochastic Dominance and Cumulative Prospect Theory

Abstract: We generalize and extend the second-order stochastic dominance condition for expected utility to cumulative prospect theory. The new definitions include preferences represented by S-shaped value functions, inverse S-shaped probability weighting functions, and loss aversion. The stochastic dominance conditions supply a framework to test different features of cumulative prospect theory. In the experimental part of the paper, we offer a test of several joint hypotheses on the value function and the probability weighting function. Assuming empirically relevant weighting functions, we can reject the inverse S-shaped value function recently advocated by Levy and Levy (2002) in favor of the S-shaped form. In addition, we find generally supporting evidence for loss aversion. Violations of loss aversion can be explained by subjects using the overall probability of winning as a heuristic.

Incentive Design under Loss Aversion

Abstract: Compensation schemes often reward success but do not penalize failure. Fixed salaries with stock options or bonuses have this feature. Yet the standard principal–agent model implies that pay is normally monotonically increasing in performance. This paper shows that, under loss aversion, there will be intervals over which pay is insensitive to performance, with the use of carrots but not sticks is frequently optimal, especially when risk aversion is low and reference income is endogenous. A further benefit of capping losses, for example through options, is to discourage reckless behavior by executives seeking to resurrect their fortunes. (JEL: F3, F4)

The loss aversion / narrow framing approach to the equity premium puzzle

Abstract: We review a recent approach to understanding the equity premium puzzle. The key elements of this approach are loss aversion and narrow framing, two well-known features of decision-making under risk in experimental settings. In equilibrium, models that incorporate these ideas can generate a large equity premium and a low and stable risk-free rate, even when consumption growth is smooth and only weakly correlated with the stock market. Moreover, they can do so for parameter values that correspond to sensible attitudes to independent monetary gambles. We conclude by suggesting some possible directions for future research.

The Loss Aversion / Narrow Framing Approach to the Equity Premium Puzzle

Abstract: We review a recent approach to understanding the equity premium puzzle. The key elements of this approach are loss aversion and narrow framing, two well-known features of decision-making under risk in experimental settings. In equilibrium, models that incorporate these ideas can generate a large equity premium and a low and stable risk-free rate, even when consumption growth is smooth and only weakly correlated with the stock market. Moreover, they can do so for parameter values that correspond to sensible attitudes to independent monetary gambles. We conclude by suggesting some possible directions for future research.

Loss Aversion Under Prospect Theory: a Parameter-Free Measurement

Abstract: A growing body of qualitative evidence shows that loss aversion, a phenomenon formalized in prospect theory, can explain a variety of field and experimental data. Quantifications of loss aversion are, however, hindered by the absence of a general preference-based method to elicit the utility for gains and losses simultaneously. This paper proposes such a method and uses it to measure loss aversion in an experimental study without making any parametric assumptions. Thus, it is the first to obtain a parameter-free elicitation of prospect theory's utility function on the whole domain. Our method also provides an efficient way to elicit utility midpoints, which are important in axiomatizations of utility. Several definitions of loss aversion have been put forward in the literature. According to most definitions we find strong evidence of loss aversion, at both the aggregate and the individual level. The degree of loss aversion varies with the definition used, which underlines the need for a commonly accepted definition of loss aversion.

Research Note---Estimating Heterogeneous Price Thresholds

Abstract: A brand choice model with heterogeneous price-threshold parameters is used to investigate a three-regime piecewise-linear stochastic utility function. The model is used to explore the relationships between aspects of consumer price sensitivity and price thresholds using hierarchical Bayes modeling with the Markov chain Monte Carlo (MCMC) method. This study contributes to the modeling literature on discontinuous likelihoods in choice models. The empirical application using our scanner panel data set shows that the reference effect and loss aversion are more marked after price thresholds are taken into heterogeneous price response models. Furthermore, loss aversion is attenuated by using price thresholds than by an aggregate (homogeneity) model without price thresholds.

Computational Aspects of Prospect Theory with Asset Pricing Applications

Abstract: We develop an algorithm to compute asset allocations for Kahneman and Tversky's (1979) prospect theory An application to benchmark data as in Fama and French (1992) shows that the equity premium puzzle is resolved for parameter values similar to those found in the laboratory experiments of Kahneman and Tversky (1979) While previous studies like Benartzi and Thaler (1995), Barberis, Huang, and Santos (2001), and Gruune and Semmler (2005) only used myopic loss aversion to explain the equity premium puzzle our paper extends this explanation of the equity premium puzzle by incorporating changing risk aversion Our extension allows reducing the degree of loss aversion from 2353 to 225, which is the value found by Kahneman and Tversky (1979) while increasing the risk aversion from 1 to 0894, which is a slightly higher value than the 088 found by Kahneman and Tversky (1979) The equivalence of these parameter settings is robust to incorporating the size and the value portfolios of Fama and French (1992) However, the optimal prospect theory portfolios found on this larger set of assets differ drastically from the optimal mean-variance portfolio

Loss Aversion? Not with Half-a-Million on the Table!

Abstract: In the television show Affari Tuoi a contestant is endowed with a sealed box containing anmonetary prize between one cent and half a million euros. In the course of the show the contestant is offered to exchange her box for another sealed box with the samendistribution of possible monetary prizes inside. This offers a unique natural laboratory for testing the predictions of expected utility theory versus prospect theory using lotteries with large stakes. While expected utility theory predicts that an individual is exactly indifferent between accepting and rejecting the exchange offer, prospect theory predictsnthat an individual should always reject the exchange offer due to the assumption of loss aversion. We find that the assumption of loss aversion is violated by 46 percent of all contestants in our recorded sample. Thus, contestants do not appear to be predominantly loss averse when dealing with lotteries involving large stakes.

Prospect Theory or Skill Signaling

Abstract: Failure is embarrassing. In gambles involving both skill and chance, we show that a strategic desire to avoid appearing unskilled generates behavioral anomalies that are typically explained by prospect theory's concepts of loss aversion, probability weighting, and framing effects. Loss aversion arises because losing any gamble, even a friendly bet with little or no money at stake, reflects poorly on the decision maker's skill. Probability weighting emerges because winning a gamble with a low probability of success is a strong signal of skill, while losing a gamble with a high probability of success is a strong signal of incompetence. Framing matters when there are multiple equilibria and the framing of a gamble affects beliefs, e.g., when someone takes a "dare" rather than admit a lack of skill. The analysis is based on models from the career concerns literature and is closely related to early social psychology models of risk taking. The results provide an alternative perspective on the existence of prospect theory behavior in managerial and financial decisions where both skill and chance are important. We identify specific situations where skill signaling makes opposite predictions than prospect theory, allowing for tests between the strategic and behavioral approaches to understanding risk.

Optimal Currency Hedging

Abstract: This paper characterizes optimal currency hedging in several models of downside risk. We consider, in turn, three models of hedging: (i) a firm that chooses its hedging policy in the presence of bankruptcy costs; (ii) an all equity firm that faces a convex tax schedule; and (iii) a firm whose manager is subject to loss aversion. In all these models, and contrary to conventional wisdom, we show that forwards dominate options as hedges of downside risk.

Loss Aversion? Not with Half-a-Million on the Table!

Abstract: In the television show Affari Tuoi a contestant is endowed with a sealed box containing a monetary prize between one cent and half a million euros. In the course of the show the contestant is offered to exchange her box for another sealed box with the same distribution of possible monetary prizes inside. This offers a unique natural laboratory for testing the predictions of expected utility theory versus prospect theory using lotteries with large stakes. While expected utility theory predicts that an individual is exactly indifferent between accepting and rejecting the exchange offer, prospect theory predicts that an individual should always reject the exchange offer due to the assumption of loss aversion. We find that the assumption of loss aversion is violated by 46 percent of all contestants in our recorded sample. Thus, contestants do not appear to be predominantly loss averse when dealing with lotteries involving large stakes.

Discrete choices and the trade off between money and time: Another test of the theory of reference-dependent preferences

Abstract: We consider binary choices on the trade-off between money and travel time, and formulate a model of reference-dependent preferences based on a linear reference-free utility function. Reference-dependence is captured by value functions that are centered at the reference. The model predicts a particular relationship between four commonly used valuation measures (willingness to pay (WTP), willingness to accept (WTA), equivalent gain (EG) and equivalent loss (EL)), and is has directly testable implications. Moreover, we show that the model allows recovering the underlying reference-free value of time. Based on a large survey data set, we estimate an econometric version of the model, allowing for both observed and unobserved heterogeneity. We find strong supporting evidence for reference-dependence in a series of tests of high statistical power. The gap between WTP and WTA is found to exceed a factor four. Loss aversion plays an important role in explaining responses; moreover, drivers are more loss averse in the time dimension than the cost dimension. We further find evidence of asymmetrically diminishing sensitivity. Finally, we show that the fraction of ´mistakes`, in the sense that participants are observed to sometimes select dominated options, varies systematically in a way consistent with the model of reference-dependence.

Foreclosure Sales: The Effects of Price Expectations, Volatility and Equity Losses

Abstract: Where borrowers are personally liable for shortfalls when they default on their mortgages, lenders have to exercise a duty of good faith in securing a reasonable value for the foreclosed property. The lender is entitled to recover the outstanding loan as quickly as possible, and is not bound to sell the foreclosed property at the highest price. Such an institutional setting allows us to study lender and borrower behavior, specifically the influence of price expectations, volatility and equity losses on foreclosure transactions using non-foreclosure transactions as a comparison. Our results show the differences in seller response to market expectations and equity losses exist across foreclosure and non-foreclosure transactions. Seller behavior matters. While price expectations, volatility and equity losses are influential factors for individual households, past price movements is the most important. This study also further seeks to distinguish loss aversion from disposition effect. By controlling for properties that suffered losses in equity but did not sell, we are able to examine the disposition effect in house owners. The result shows that there is disposition effect for non-foreclosure properties, where individual homeowners are reluctant to sell if the properties suffer losses.

Measuring Consumer Risk-Return Tradeoffs

Abstract: Consumer choice occurs over multiple products and services, each comprising multiple risks. In this paper, we present a new market research technique to measure consumers' preferences over large spaces of risks. We first describe the method, present its psychological and analytical motivation, and then report the results of empirical tests of reliability and validity, both within testing sessions and across the span of one year. The method is used to estimate the coefficient of relative risk aversion and the loss aversion parameter for a sample of adults saving for retirement. The new technique passes tests of reliability and validation and captures individual differences based on age and income. It also identifies two sub-populations, one best fit by a more classical model of risk preference, and the other by a behavioral model which incorporates loss aversion.

Happiness and Loss Aversion: When Social Participation Dominates Comparison

Abstract: A central finding in happiness research is that a person's income relative to the average income in her social reference group is more important for her life satisfaction than the absolute level of her income. This dependence of life satisfaction on relative income can be related to the reference dependence of the value function in Kahneman and Tversky's (1979) prospect theory. In this paper we investigate whether the characteristics of the value function like concavity for gains, convexity for losses, and loss aversion apply to the dependence of life satisfaction on relative income. This is tested with a new measure for the reference income for a large German panel for the years 1984-2001. We find concavity of life satisfaction in positive relative income, but unexpectedly strongly significant concavity of life satisfaction in negative relative income as well. The latter result is shown to be robust to extreme distortions of the reported-life-satisfaction scale. It implies a rising marginal sensitivity of life satisfaction to more negative values of relative income, and hence loss aversion (in a wide sense). This may be explained in terms of increasing financial obstacles to social participation.