Showing papers on "Loss aversion published in 2009"

Reference Points and Effort Provision

Abstract: A key open question for theories of reference-dependent preferences is what determines the reference point. One candidate is expectations: what people expect could affect how they feel about what actually occurs. In a real-effort experiment, we manipulate the rational expectations of subjects and check whether this manipulation influences their effort provision. We find that effort provision is significantly different between treatments in the way predicted by models of expectation-based reference-dependent preferences: if expectations are high, subjects work longer and earn more money than if expectations are low.

A Structural Analysis of Disappointment Aversion in a Real Effort Competition

Abstract: We develop a novel computerized real effort task, based on moving sliders across a screen, to test experimentally whether agents are disappointment averse when they compete in a real effort sequential-move tournament. Our theory predicts that a disappointment averse agent, who is loss averse around her endogenous expectations-based reference point, responds negatively to her rival's effort. We find significant evidence for this discouragement effect, and use the Method of Simulated Moments to estimate the strength of disappointment aversion on average and the heterogeneity in disappointment aversion across the population.

Thinking like a trader selectively reduces individuals' loss aversion

Abstract: Research on emotion regulation has focused upon observers' ability to regulate their emotional reaction to stimuli such as affective pictures, but many other aspects of our affective experience are also potentially amenable to intentional cognitive regulation. In the domain of decision-making, recent work has demonstrated a role for emotions in choice, although such work has generally remained agnostic about the specific role of emotion. Combining psychologically-derived cognitive strategies, physiological measurements of arousal, and an economic model of behavior, this study examined changes in choices (specifically, loss aversion) and physiological correlates of behavior as the result of an intentional cognitive regulation strategy. Participants were on average more aroused per dollar to losses relative to gains, as measured with skin conductance response, and the difference in arousal to losses versus gains correlated with behavioral loss aversion across subjects. These results suggest a specific role for arousal responses in loss aversion. Most importantly, the intentional cognitive regulation strategy, which emphasized “perspective-taking,” uniquely reduced both behavioral loss aversion and arousal to losses relative to gains, largely by influencing arousal to losses. Our results confirm previous research demonstrating loss aversion while providing new evidence characterizing individual differences and arousal correlates and illustrating the effectiveness of intentional regulation strategies in reducing loss aversion both behaviorally and physiologically.

Family Violence and Football: The Effect of Unexpected Emotional Cues on Violent Behavior

Abstract: Family violence is a pervasive and costly problem, yet there is no consensus on how to interpret the phenomenon of violence by one family member against another Some analysts assume that violence has an instrumental role in intra-family incentives Others argue that violent episodes represent a loss of control that the offender immediately regrets In this paper we specify and test a behavioral model of the latter form in which the strength of an emotional cue depends on outcomes relative to expectations and individuals exhibit loss aversion Our key hypothesis is that negative emotional cues -- benchmarked relative to a rationally expected reference point -- make a breakdown of control more likely We test this hypothesis using data on police reports of family violence on Sundays during the professional football season Controlling for location and time fixed effects, weather factors, the pre-game point spread, and the size of the local viewing audience, we find that upset losses by the home team (losses in games that the home team was predicted to win by more than 3 points) lead to an 8 percent increase in police reports of at-home male-on-female intimate partner violence There is no corresponding effect on female-on-male violence Consistent with the behavioral prediction that losses matter more than gains, upset victories by the home team have (at most) a small dampening effect on family violence We also find that unexpected losses in highly salient or frustrating games have a 50% to 100% larger impact on rates of family violence The evidence that payoff-irrelevant events affect the rate of family violence leads us to conclude that at least some fraction of family violence is better characterized as a breakdown of control than as an intra-family incentive system More generally, the empirical findings suggest that gain-loss utility with a rational reference point could be a useful approach to modeling other cues and visceral influences

Poverty, Risk Aversion, and Path Dependence in Low-Income Countries: Experimental Evidence from Ethiopia

Abstract: In most low-income countries, rural households depend on mixed rain-fed agriculture/livestock production, which is very risky. Due to numerous market failures, there are few ways to shift risks to third parties. The literature has focused on what determines the responses of households in such environments. Of special concern are path dependencies in which households experiencing failure are prone to further failure and potential poverty traps. This paper estimates levels and determinants of risk aversion in the highlands of Ethiopia. We find high risk aversion and evidence that constraints have important impacts on risk-averting behavior with perhaps significant implications for long-term poverty. The results also suggest the possibility of path dependence and offer insights into links between risk aversion and poverty traps. Copyright 2009, Oxford University Press.

Prospect Theory and the Brain

Abstract: Publisher Summary This chapter highlights the behavioral and neuroscience work on the prospect theory and the neuroscience of behavioral decision-making. Several applications of prospect theory from neuroeconomics to decision analysis to behavioral finance require individual assessment of value and weighting functions. In order to measure the shape of the value and weighting functions exhibited by participants in the laboratory, one must first discuss how these functions can be formally modeled. The field of neuroeconomics is providing a rapidly increasing amount of data regarding the phenomena that lie at the heart of prospect theory, such as framing effects and loss aversion. It is clear that the demonstrations of neural correlates of several of the fundamental behavioral phenomena underlying prospect theory (loss aversion, framing effects, and probability weighting distortions) provide strong evidence to even the most entrenched rational choice theorists that these anomalies are real. The data have also started to provide more direct evidence regarding specific claims of the theory.

Additive Utility in Prospect Theory

Abstract: Prospect theory is currently the main descriptive theory of decision under uncertainty. It generalizes expected utility by introducing nonlinear decision weighting and loss aversion. A difficulty in the study of multiattribute utility under prospect theory is to determine when an attribute yields a gain or a loss. One possibility, adopted in the theoretical literature on multiattribute utility under prospect theory, is to assume that a decision maker determines whether the complete outcome is a gain or a loss. In this holistic evaluation, decision weighting and loss aversion are general and attribute-independent. Another possibility, more common in the empirical literature, is to assume that a decision maker has a reference point for each attribute. We give preference foundations for this attribute-specific evaluation where decision weighting and loss aversion are depending on the attributes.

Loss-Aversion and Household Portfolio Choice

Abstract: In this paper we empirically test if loss-aversion affects household participation in equity markets, household allocations to equity, and household allocations between mutual funds and individual stocks. Using household survey data, we obtain direct measures of each surveyed household’s loss-aversion coefficient from questions involving hypothetical payoffs. We find that higher loss-aversion is associated with a lower probability of participation. We also find that higher loss-aversion reduces the probability of direct stockholding by significantly more than the probability of owning mutual funds. After controlling for sample selection we do not find a relationship between loss-aversion and portfolio allocations to equity.

Psychology, Financial Decision Making, and Financial Crises

Abstract: It is understandable that people ask how the current financial crisis could happen. As the market actors appear irrational, it is also understandable that people—lay people and experts alike—believe that psychological factors play a decisive role. Is there evidence for such a role, and what is the evidence? This monograph reviews, evaluates, and discusses research—primarily psychological research —that can potentially increase our understanding of the psychological antecedents and consequences of financial crises. It also highlights important areas where more psychological research is needed to advance this understanding. Individuals generally use their cognitive and other resources in sensible ways, and collectively they have developed procedures that effectively regulate economic and other social transactions. But sometimes such transactions are so complex that they exceed the ability of individuals or groups to manage effectively. It is therefore essential that scientific knowledge of people’s cognitive and other limitations be brought to bear on the issue of how to improve decision making in these domains. Financial markets such as those for stocks and credit arguably are among those domains in which actors’ capacity to make rational judgments and decisions is frequently overtaxed. In product markets with full competition, prices more closely represent the true value of the products; uncertainty in such contexts is thus minimized and the conditions are relatively conducive for making good judgments. But in stock markets, stock prices, due to excessive trading, are more volatile than they would be if they reflected stocks’ true value. Psychological explanations of excessive trading include cognitive biases such as overconfidence and overoptimism, risk aversion in the face of sure gains and risk taking and loss aversion in the face of possible losses, and influences of nominal representation (the money illusion) of stock prices. If no cognitive biases (strengthened by affective influences) existed or only some actors were susceptible to such biases, individual irrationality in stock markets would possibly be eliminated. But evidence shows such biases are in fact pervasive. In order to understand stock market booms and busts, it is also necessary to take into account the tendency among actors to imitate each other. Furthermore, in destabilized stock markets, experts are less likely to lose money than are lay people, who lack skill in constructing stock portfolios that effectively diversify risk. Credit markets allow people to lend money for investments that will pay off in the future. Yet under extreme circumstances, credit lenders offer loans without appropriately considering the risk borrowers run of not being able to pay their monthly installments. Global credit excesses in general, and the current subprime mortgage crisis in particular, also show that households often accept risky loans. Furthermore, their preparedness to use credit has been increasing and credit is no longer solely a means of investing in the personal future. An example is that, in the new member states of the European Union, citizens having a desire for a Western living standard are increasingly prepared to use credit. Credit use is a process consisting of different stages of decision making, starting with purchasing a product for borrowed money and ending with paying back the borrowed money. Decisions to save now in order to buy a desired product in the future, or not to save but to borrow money and save later, are intertemporal choices with consequences at different points in time. The rewards of possessing a commodity immediately or in the future are traded off against the costs of paying back borrowed money in installments or paying the price all at once in the future. Purchase decisions involve two interacting choices preceded by information search: Choice of the product and choice of the method of financing. Only a small percentage of credit users search extensively for credit information prior to taking up credit. The probability of search increases with the borrowed amount, the amount of previously experienced debts, higher income, and higher educational level, and it also is higher for credit novices. Furthermore, credit users fail to correctly anticipate the decrease in the experienced pleasure from the credit-financed product. They also experience decreasing pleasure with the acquired product and increasing strains from

Causes, consequences, and cures of myopic loss aversion - an experimental investigation

Abstract: We examine in an experiment the causes, consequences and possible cures of myopic loss aversion (MLA) for investment behaviour under risk. We find that both, investment horizons and feedback frequency contribute almost equally to the effects of MLA. Longer investment horizons and less frequent feedback lead to higher investments. However, when given the choice, subjects prefer on average shorter investment horizons and more frequent feedback. Exploiting the status quo bias by setting a long investment horizon or low feedback frequency as a default turns out to be a successful behavioural intervention that increases investment levels.

Institutional Investors, Past Performance, and Dynamic Loss Aversion

Abstract: Using a proprietary database of currency trades, this paper explores the effects of trading gains and losses on risk-taking among large institutional investors. We find that institutional investors, unlike individuals, are not prone to the disposition effect. Instead, institutions aggressively reduce risk following losses and mildly increase risk following gains. This asymmetry is more pronounced later in the calendar year and among older and more experienced funds. We show that such performance dependence is consistent with dynamic loss aversion (Barberis, Huang, and Santos (2001)) and overconfidence. In addition, prior institutional gains and losses have palpable implications for future prices.

Prospect theory and stochastic multicriteria acceptability analysis (SMAA)

Abstract: We consider problems where multiple decision makers (DMs) want to choose their most preferred alternative from a finite set based on multiple criteria. Several approaches to support DMs in such problems have been suggested. Prospect theory has appealed to researchers through its descriptive power, but rare attempts have been made to apply it to support multicriteria decision making. The basic idea of prospect theory is that alternatives are evaluated by a difference function in terms of gains and losses with respect to a reference point. The function is suggested to be concave for gains and convex for losses and steeper for losses than for gains. Stochastic multicriteria acceptability analysis (SMAA) is a family of multicriteria decision support methods that allows representing inaccurate, uncertain, or partly missing information about criteria measurements and preferences through probability distributions. SMAA methods are based on exploring the weight and criteria measurement spaces in order to describe weights that would result in a certain rank for an alternative. This paper introduces the SMAA-P method that combines the piecewise linear difference functions of prospect theory with SMAA. SMAA-P computes indices that measure how widely acceptable different alternatives are with assumed behavior. SMAA-P can be used in decision problems, where the DMs’ preferences (weights, reference points and coefficients of loss aversion) are difficult to assess accurately. SMAA-P can also be used to measure how robust a decision problem is with respect to preference information. We demonstrate the method by reanalyzing a past real-life example.

Decision-making under uncertainty – A field study of cumulative prospect theory

Abstract: The presented research tests cumulative prospect theory (CPT, [Kahneman, D., Tversky, A., 1979. Prospect theory: An analysis of decision under risk. Econometrica 47, 263–291; Tversky, A., Kahneman, D., 1981. The framing of decisions and the psychology of choice. Science 211, 453–480]) in the financial market, using US stock option data. Option prices possess information about actual investors’ preferences in such a way that an exploitation of conventional option analysis, along with theoretical relationships, makes it possible to elicit investor preferences. The option data in this study serve for estimating the two essential elements of the CPT, namely, the value function and the probability weighting function. The main part of the work focuses on the functions’ simultaneous estimation under CPT original parametric specification. The shape of the estimated functions is found to be in line with theory. Comparing to results of laboratory experiments, the estimated functions are closer to linearity and loss aversion is less pronounced.

The Origin of Behavior

Abstract: We propose a single evolutionary explanation for the origin of several behaviors that have been observed in organisms ranging from ants to human subjects, including risk-sensitive foraging, risk aversion, loss aversion, probability matching, randomization, and diversification. Given an initial population of individuals, each assigned a purely arbitrary behavior with respect to a binary choice problem, and assuming that offspring behave identically to their parents, only those behaviors linked to reproductive success will survive, and less reproductively successful behaviors will disappear at exponential rates. When the uncertainty of reproductive success is systematic, natural selection yields behaviors that may be individually sub-optimal but are optimal from the population perspective; when reproductive uncertainty is idiosyncratic, the individual and population perspectives coincide. This framework generates a surprisingly rich set of behaviors, and the simplicity and generality of our model suggest that these derived behaviors are primitive and nearly universal within and across species.

Theories of choice under risk: Insights from financial markets

Abstract: To date, the plausibility of theories of choice under risk hinges are mainly on experimental evidence. This paper devises and implements an approach amenable of assessing the performance of three families of models (expected utility, rank-dependent expected utility, and the cumulative prospect theory) using information from financial asset markets . Our findings unequivocally support reference-point dependence, diminishing marginal sensitivity, loss aversion, and nonlinear weighting of (gain and loss) physical probabilities. The empirical observations are found to be robust to, inter alia, the parameterization of the utility and probability weighting functions, “day-of-the-week effects”, the choice of a reference point, and the introduction of possible, low-probability market crashes (peso component).

A Model of Consumer Inertia with Applications to Dynamic Pricing

Abstract: This paper introduces a decision model of consumer inertia. Consumers exhibit inertia when they have an inherent bias to delay purchases. Inertia may induce consumers to wait even when it is optimal to buy immediately. We embed our decision model within a dynamic pricing context. There is a firm that sells a fixed capacity over two time periods to an uncertain number of both rational and inertial consumers. We find that consumer inertia has both positive and negative effects on profits: it decreases demand (in period one) but intensifies competition among consumers for the product (in period two). We show that our model of inertia is consistent with well-established behavioral regularities, such as loss aversion and probability weighting in the sense of prospect theory, and hyperbolic time preferences. We offer practical recommendations for firms to influence the level of consumer inertia. These include offering returns policies (to mitigate potential consumer losses), providing decision aids (to avoid perception errors), and offering flexible payment options (to lower transaction costs).

A Prospect Theory Model of Resource Allocation

Abstract: Many papers in organization theory and strategy use prospect theory, but few derive their hypotheses from prospect theory's formal model. This paper develops a prospect theory model of resource allocation under risk where projects have both positive and negative adjusted payoffs. The model assumes consistent value (rather than profit) maximizing behavior and demonstrates how resources, risk propensity, and reference levels interact to determine allocations to risky projects. The analysis shows that prospect theory's parameters interact in complex ways to influence risk taking, which makes simple predictions difficult. Overall, loss aversion and the reference point dominate the results, with curvature of the value function playing a secondary role and the maximum risk aversion occurring for firms near their reference points, not for firms above their reference points.

Decision Support for Retirement Portfolio Management: Overcoming Myopic Loss Aversion via Technology Design

Abstract: As firms continue to abandon pensions in favor of employee-managed retirement plans, tremendous demands are being placed on the decision-making proficiency of future retirees. As reflected in the equity premium puzzle, individual investors tend to hold overly conservative portfolios that provide meager payoffs over time. Consequently, there is growing concern that the vast majority of retirement accounts might be insufficiently funded when employees reach retirement. Given that most retirement plans can now be managed online, a potential solution lies in designing a Web-based decision support system (DSS) that helps future retirees make more-profitable portfolio management decisions. This paper reports the results of a study in which 159 retirement plan participants were asked to use an experimental website to manage a portfolio of retirement investments over a simulated 30-year period. Using a psychological approach toward designing the DSS, myopic loss aversion is put forth as a theoretical explanation for the psychological mechanisms that encourage investors to hold overly conservative portfolios. Armed with this knowledge, three design features---information horizon, system restrictiveness, and decisional guidance---are implemented as part of an overarching design strategy targeted at increasing investors' willingness to take calculated risks. The results indicate that investor conservatism diminishes when the DSS presents prospective probabilities and payoffs over long time horizons. In contrast, short-term information horizons constitute a major stumbling block for investors. However, when confronted with short-term information horizons, risk aversion can be successfully counteracted by configuring a DSS to either restrict the frequency of decisions or to suggest a relatively aggressive portfolio allocation. These findings carry important implications for theory and practice.

Taste uncertainty and status quo effects in consumer choice

Abstract: We use reference-dependent expected utility theory to develop a model of status quo effects in consumer choice. We hypothesise that, when making their decisions, individuals are uncertain about the utility that will be yielded by their consumption experiences in different ‘taste states’ of the world. If individuals have asymmetric attitudes to gains and losses of utility, the model entails acyclic reference-dependent preferences over consumption bundles. The model explains why status quo effects may vary substantially from one decision context to another and why some such effects may decay as individuals gain market experience.

Prospect theory for stock markets: Empirical evidence with time-series data ☆

Abstract: Based on the loss aversion model of asset pricing, this paper explores empirical evidence on the prospect theory for stock markets with time-series data. The analysis, using a state-space model, shows that previous gains and losses may have asymmetric effects on investment behavior, pointing to the possibility of break-even effects ignored by asset-pricing models using prospect theory.

Policy Bundling to Overcome Loss Aversion: A Method for Improving Legislative Outcomes

Abstract: Policies that would create net benefits for society but would also involve costs frequently lack the necessary support to be enacted because losses loom larger than gains psychologically. To reduce this harmful consequence of loss aversion, we propose a new type of policy bundling technique in which related bills that have both costs and benefits are combined. Using a laboratory study, we confirm across a set of four legislative domains that this bundling technique increases support for bills that have both costs and benefits. We also demonstrate that this effect is due to changes in the psychology of decision making, rather than voters’ willingness to compromise and support a bill they weakly oppose when that bill is bundled with one they strongly support.

The Relationship Between Risk Attitudes and Heuristics in Search Tasks : A Laboratory Experiment

Abstract: Experimental studies of search behavior suggest that individuals stop searching earlier than the optimal, risk-neutral stopping rule predicts. Two different classes of decision rules could generate this behavior: rules that are optimal conditional on utility functions departing from risk neutrality, or heuristics derived from limited cognitive processing capacities and satisficing. To discriminate between these possibilities, we conducted an experiment that consists of a search task as well as a lottery task designed to elicit utility functions. We find that search heuristics are not related to measures of risk aversion, but to measures of loss aversion.

Statistical discrimination in labor markets: An experimental analysis

Abstract: This article reports results from controlled laboratory experiments designed to study second-moment (that is, risk-based) statistical discrimination in a labor market setting. Since decision makers may not view risk in the same way as economists or statisticians (that is, risk = variance of distribution), we also examine alternative measures of risk: the support of the distribution and the probability of earning less than the expected (maximum) profits for the employer. Our results indicate that employers made statistically discriminatory wage offers consistent with loss aversion in our full sample (though the result is driven by the male employer subsample). If one can transfer these results outside of the laboratory, they indicate that discrimination estimates based only on first-moment (mean-based) discrimination are biased. The public policy implication is that efforts and legislation aimed at reducing discrimination of various sorts face an additional challenge in trying to identify and limit relatively hidden, but significant, forms of statistical discrimination.

An Empirical Investigation into the Excessive-Choice Effect

Abstract: Recent marketing and psychological studies have shown that more choice does not always benefit consumers. This excessive-choice effect (ECE) is examined empirically using food items in four experiments. The first experiment investigates whether people would voluntarily reduce their choice-set size. The second seeks to replicate previous experimental results. The third and fourth experiments employ nonhypothetical Becker-DeGroot-Marschak (BDM) soda auctions and hypothetical ground beef choice experiments to further detect the prevalence of the ECE in alternative settings and explore the role of personality in decision tasks. Results suggest the ECE exists, but is less prevalent than previous studies suggest. Over the past two decades, there has been an explosive growth in the field of behavioral economics, which focuses on the interface between economics and psychology. Behavioral economics has contributed insights related to loss aversion, the endowment effect, bounded rationality, and anchoring, to name a few. One psychological finding that is highly relevant to the practice of economics, but that has received little recent attention by economists, is the excessive-choice effect (ECE). This article describes the ECE and investigates the presence and magnitude of the effect in four experiments. The standard economic model of the consumer assumes that utility is weakly increasing in choice-set size. If more choices are available, consumers can reconsider their purchasing behavior, either by discovering a consumption bundle yielding higher utility or remaining at the old bundle and utility level. This standard model stems from the assumption of perfect rationality, perfect knowledge, and costless cognitive processing. The standard model is periodically questioned by empirical observation, inducing researchers to seek bounded rationality models that explain the empirical puzzle.