Behavioral Finance: Prospect Theory Analysis

Introduction to Paper: According to conventional financial theory, the world and its participants are, for the most part, rational wealth maximizers. However, there are many instances where emotion and psychology influence our decisions, causing us to behave in unpredictable or irrational ways. It is a relatively new field that seeks to combine behavioral and cognitive psychological theory with conventional economics and finance to provide explanations for why people make irrational financial decisions. In the present scenario, behavioral finance is becoming an integral part of the decisionmaking process, because it heavily influences investors performance. They can improve their performance by recognizing the biases and errors of judgment to which all of us are prone. Understanding the behavioral finance will help the investors to select a better investment instrument and they can avoid repeating the expensive errors in future. The presence of anomalies in conventional economic theory was a big contributor to the formation of behavioral finance. These so-called anomalies, and their continued existence, directly violate modern financial and economic theories, which assume rational and logical behavior. Kahneman and Tversky developed the Prospect theory in 1979 which is an alternative model to the Expected Utility Theory. This model contends that people value gains and losses differently, and, as such, will base decisions on perceived gains rather than perceived losses. Thus, if a person were given two equal choices, one expressed in terms of possible gains and other in possible losses, people would choose the former even when they achieve the same economic end result. In 1992, Kahneman and Tversky made further development and a variant of Prospect Theory called as Cumulative Prospect Theory. The difference is that weighing is applied to the Rank-Dependent Expected Utility Theory, rather than to the probabilities of individual outcomes. This paper provides an insight on the top two papers written in connection with Prospect Theory.

Abstract of the top 2 papers in connection with Prospect Theory:

1. Kahneman and Tversky, 1979.

This paper presents a critique of expected utility theory as a descriptive model of decision making under risk, and develops an alternative model, called prospect theory. Choices among risky prospects exhibit several pervasive effects that are inconsistent with the basic tenets of utility theory. In particular, people underweight outcomes that are merely probable in comparison with outcomes that are obtained with certainty. This is called the certainty effect, contributes to risk aversion in choices involving sure gains and to risk seeking in choices involving sure losses. In addition, people generally discard components that are shared by all prospects under consideration. This is called the isolation effect, leads to inconsistent preferences when the same choice is presented in different forms. An alternative theory of choice is developed, in which value is assigned to gains and losses rather than to final assets and in which probabilities are replaced by decision weights. The value function is normally concave for gains, commonly convex for losses, and is generally steeper for losses than for gains. Decision weights are generally lower than the corresponding probabilities, except in the range of low probabilities. Overweighting of low probabilities may contribute to the attractiveness of both insurance and gambling.
2. Tversky and Kahneman, 1992.

We develop a new version of prospect theory that employs cumulative rather than separable decision weights and extends the theory in several respects. This version, called cumulative prospect theory, applies to uncertain as well as to risky prospects with any number of outcomes, and it allows different weighting functions for gains and for losses. Two principles, diminishing sensitivity and loss aversion, are invoked to explain the characteristic curvature of the value function and the weighting functions. A review of the experimental evidence and the results of a new experiment confirm a distinctive fourfold pattern of risk: risk aversion for gains and risk seeking for losses of high probability; risk seeking for gains and risk aversion for losses of low probability.

Important people who contributed to the Prospect Theory concept in Behavioral Finance: Daniel Kahneman: Born in 1934, Kahneman is an Israeli-American psychologist and Nobel laureate, notable for his work on the psychology of judgment and decision-making, behavioral economics and hedonic psychology. In 2002, Kahneman received the Nobel Memorial Prize in Economics, despite being a research psychologist, for his work in Prospect theory in collaboration with Amos Tversky. Currently he is a professor emeritus of psychology and public affairs at Princeton Universitys Woodrow Wilson School. Amos Tversky: Born in 1937, Tversky was a cognitive and mathematical psychologist, a pioneer of cognitive science, a longtime collaborator of Daniel Kahneman, and a key figure in the discovery of systematic human cognitive bias and handling of risk. His early work with Kahneman focused on the psychology of prediction and probability judgment. Amos Tversky and Daniel Kahneman worked together to develop prospect theory, which aims to explain irrational human economic choices and is considered one of the seminal works of behavioral economics.

Quotes:
1. Kahneman and Tverskys (1979) Prospect theory: An analysis of decision under

risk is the second most cited paper in economics during the period, 1975 2000 (Coupe, in press; Laibson & Zeckhauser, 1998). Wu, Zhang and Gonzalez (2004)
2. Prospect Theory was developed by Kahneman and Tversky (1979). In its original

form, it is concerned with behaviour of decision makers who face a choice between two alternatives. The definition in the original context is: Decision making under risk can be viewed as a choice between prospects and gambles. Decisions subject to risk are deemed to signify a choice between alternative actions, which are associated with particular probabilities (prospects) or gambles. The model was later elaborated and modified. Goldberg and Von Nitzsch (2000)
3. Prospect theory, which was developed by Kahneman and Tversky (1979), is one

of the most quoted and best-documented phenomena in economic psychology. The theory states that we have an irrational tendency to be less willing to gamble with profits than with losses. Tvede (1999)
4. Not very long after expected utility theory was formulated by Von Neumann and

Morgenstern (1944) questions were raised about its value as a descriptive model (Allais, 1953). Recently Kahneman and Tversky (1979) have proposed an alternative descriptive model of economic behaviour that they call prospect theory. Thaler (1980)
5. If Richard Thalers concept of mental accounting is one of two pillars upon which

the whole of behavioral economics rests, then prospect theory is the other. Belsky and Gilovich (1999)
6. In a nutshell, prospect theory assumes that investors utility functions depend on

changes in the value of their portfolios rather than the value of the portfolio. Put another way, utility comes from returns, not from the value of assets. Cornell (1999)

Definition of Concepts: Behavioral Finance: A field of finance that proposes psychology-based theories to explain stock market anomalies. Within behavioral finance, it is assumed that the information structure and the characteristics of market participants systematically influence individuals investment decision as well as market outcomes. Cognitive Psychology: It is the branch of psychology that studies mental processes including how people think, perceive, remember and learn. Heuristic: It is an adjective for experience-based technique that helps in problem solving, learning and discovery. Heuristics stand for strategies using readily accessible, though loosely applicable, information to control problem solving in human beings. Expected Utility Hypothesis: It is a theory of utility in which betting preferences with regard to uncertain outcomes (gambles) are represented by a function of payouts (whether in money or other goods), the probabilities of occurrence, risk aversion, and the different utility of the same payout to people with different assets or personal preferences. Loss Aversion: It is an important psychological concept which receives increasing attention in economic analysis. The investor is a risk-seeker when faced with prospect of losses, but is risk-averse when faced with the prospects of enjoying gains. The phenomenon is called loss aversion. Equity Premium Puzzle: It is based on the observation that in order to reconcile the much higher return on equity stock compared to government bonds, individuals must have implausibly high risk aversion according to standard economics models. Endowment Effect: It is a hypothesis that people value a good or service more once their property right to it has been established. Mental Accounting: It attempts to describe a process whereby by people code, categorize and evaluate economic outcomes. Allais Paradox: It is a choice problem designed by Maurice Allais to show an inconsistency of actual observed choices with the predictions of Expected Utility Theory.

The Rank-Dependent Expected Utility Model: It is a generalized expected utility model of choice under uncertainty, designed to explain the behaviour observed in the Allais Paradox, as well as for the observation that many people both purchase lottery tickets (implying risk-loving preferences) and insure against losses (implying risk aversion). Disposition Effect: It is an anomaly discovered in behavioral finance. It relates to the tendency of investors to sell shares whose price has increased, while keeping assets that have dropped in value. Investors are less willing to recognize losses (which they would be forced to do if they sold assets which had fallen in value), but are more willing to recognize gains. Pseudocertainity Effect: It is a concept from prospect theory. It refers to peoples tendency to make risk averse (avoiding risk) choices if the expected outcome is positive, but make risk-seeking choices to avoid negative outcomes. Their choices can be affected by simply reframing the descriptions of the outcome without changing the actual utility. Stochastic Dominance: It is a form of stochastic ordering (quantifying the concept of one random variable being bigger than another). The term in used in decision theory and decision analysis to refer to situations where one gamble can be ranked as superior to another gamble. Cognitive Bias: It is the human tendency to make systematic errors in certain circumstances based on cognitive factors rather than evidence. Such biases can result from information-processing shortcuts called heuristics. The Framing Effect: It is one of the cognitive biases. It describes that presenting the same option in different formats can alter peoples decisions. Specifically, individuals have a tendency to select inconsistent choices, depending on whether the question is framed to concentrate on losses or gains. Prospect Theory: A theory that people value gains and losses differently and, as such, will base decisions on perceived gains rather than perceived losses. Thus, if a person were given two equal choices, one expressed in terms of possible gains and the other in possible losses, people would choose the former.

Prospect Theory: Kahneman and Tversky, 1979 This theory was developed by Daniel Kahneman, professor at Princeton Universitys Department of Psychology, and Amos Tversky in 1979 as a psychologically realistic alternative to Expected Utility Theory. It allows one to describe how people make choices in situations where they have to decide between alternatives that involve risk, e.g., in financial decisions. Starting from empirical evidence, the theory describes how individuals evaluate potential losses and gains. In the original formulation the term prospect refers to lottery.

The theory describes such decision processes as consisting of two stages, editing and evaluation. In the first, possible outcomes of the decision are ordered following some heuristic. In particular, people decide which outcomes they see as basically identical and they set a reference point and consider lower outcomes as losses and larger as gains. The formula that Kahneman and Tversky observe in the evaluation phase is given by: where outcomes and are the potential

their respective probabilities. v is a so-called value function

that assigns a value to an outcome. The value function (sketched in the Figure) which passes through the reference point is s-shaped and, as its asymmetry implies, given the same variation in absolute value, there is a bigger impact of losses than of gains (loss aversion). In contrast to Expected Utility Theory, it measures losses and gains, but not absolute wealth. The function w is called a probability weighting function and expresses that people tend to overreact to small probability events, but under react to medium and large probabilities.

Applications: 1. Certain behaviors in economics such as the Disposition Effect can be explained using the Prospect Theory. The Disposition Effect can be avoided by changing our mental approach on how we perceive the new information we get.
2. The Pseudocertainity Effect provides an explanation as to why the same investor will

invest in an insurance company and also buy a lottery ticket. 3. An important implication of Prospect Theory is that the way economic agents subjectively frame an outcome or transaction in their mind affects the utility they accept or receive. 4. The portfolios of prospect theory investors are sensitive to the location of reference point. For low reference points, prospect theory investors choose traditional portfolios. Higher reference points induce risk-seeking behavior, or the reluctance to engage in trade. 5. Prospect theory has been used to explain the profitability of value strategy and the predictability of past returns. 6. Prospect Theory has played a vital role in explaining the under-pricing and overpricing of Initial Public Offerings.

Prospect Theory: Kahneman and Tversky, 1992 Perhaps the most important change to the original prospect theory is that of Tversky and Kahneman (1992) about how probabilities are transformed. The original specification in Kahneman and Tversky (1979) applies only to binomial gambles, and violates the firstorder stochastic dominance property. The essence of change in Tversky and Kahneman (1992) is that the transformation is first applied to the cumulative density function rather than directly to the probabilities. Thus, the Tversky and Kahneman (1992) version is usually called the cumulative prospect theory. It applies to the most general gambles and is also consistent with first- order stochastic dominance.

The main observation of Cumulative Prospect Theory is that people tend to think of possible outcomes usually relative to a certain reference point rather than to a final status, a phenomenon which is called the framing effect. Moreover they have different risk attitudes towards gains and losses and care generally more about potential losses and potential gains. Finally, people tend to overweigh extreme, but unlikely events, but underweight average events. Therefore, in Cumulative Prospect Theory weighing is applied to the cumulative probability distribution function, as in rank-dependent expected utility theory, rather than to the probabilities of individual outcomes. Cumulative prospect theory has been applied in various situations which appear inconsistent with standard economic rationality, in particular with equity premium puzzle, various gambling and betting puzzles, endowment effect, etc.

Conclusion: Prospect theory refers to an idea created by Drs. Kahneman and Tversky that essentially determined that people do not encode equal levels of joy and pain to the same effect. The average individuals tend to be more loss sensitive (in the sense, he/she will feel more pain in receiving a loss compared to the amount of joy felt from receiving an equal amount of gain). Prospect theory is a descriptive model of decision making under uncertainty. Under prospect theory, people evaluate risk using a value function that is defined over gains and losses, is concave over gains and convex over losses, and is kinked at the origin; and using transformed rather than objective probabilities by applying a weighting function. Though the various examples given under Prospect Theory are widely observed, one must note that all the investors will not suffer from the same illusion simultaneously. The susceptibility of an investor to a particular illusion is likely to be a function of several variables. For example, there is suggestive evidence that the experience of the investor has an explanatory role in his regard with less experienced investors being prone to representativeness while more experienced investors commit gamblers fallacy. Similarly, behavioral factors play a vital role in the decision making process of the investors. Hence the investors have to take necessary steps to minimize or avoid illusions for influencing in their decision making process, investment decisions in particular.

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2. Barberis, Nicholas, Ming Huang, and Tano Santos, 2001. Prospect Theory and Asset

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3. Thayer Watkins, San Jose State University, Economics Department. Kahneman and

Tverskys Prospect Theory.

4. Albert Phung, University of Alberta. Behavioral Finance: Key Concepts Prospect

Theory.
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Decisions.
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Finance.
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