Ch03.pdf
- 1. Chapter 3: Prospect Theory, Framing
and Mental Accounting
Powerpoint Slides to accompany Behavioral
Finance: Psychology, Decision-making and Markets
by Lucy F. Ackert & Richard Deaves
Ā©2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
posted to a publicly available website, in whole or in part.
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- 2. Prospect theory
ā¢ Prospect theory was developed by Kahneman
and Tversky base on observing actual behavior.
ā¢ Experimental evidence says that people often
behave contrary to expected utility theory.
ā¢ Expected utility theory is normative.
ā What people should do
ā¢ While prospect theory is positive.
ā What people do
2
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posted to a publicly available website, in whole or in part.
- 3. Risk aversion vs. risk seeking
ā¢ Prospect pair 1 -- choose between:
ā A: (.8, 4,000)
ā B: (3,000)
ā Note: with certainty no need to show a probability
ā¢ Prospect pair 2 ā choose between:
ā A: (.8, -4,000)
ā B: (-3,000)
ā¢ Results for 1: most prefer sure $3000 which is consistent with
risk aversion.
ā¢ Results for 2: most do not prefer sure -$3000 ā this is
inconsistent with risk aversion.
ā¢ Implies people are risk seeking in negative domain (reflection
effect)!
3
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posted to a publicly available website, in whole or in part.
- 4. Loss aversion
ā¢ Prospect pair 3 -- choose between:
ā A: no prospect
ā B: (.5, $50, -$50)
ā¢ Most choose A.
ā¢ Despite risk aversion in positive domain and risk
seeking in negative domain, losses loom larger than
gains.
ā¢ This is called loss aversion.
4
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posted to a publicly available website, in whole or in part.
- 5. Development of prospect theory
ā These and other results led to prospect theory as an
alternative to expected utility theory.
ā Key precepts:
ā¢ Value function is in terms of gains or losses
ā¢ Risk aversion in positive domain
ā¢ Risk seeking in negative domain
ā¢ Loss aversion
5
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posted to a publicly available website, in whole or in part.
- 6. Prospect theory value function
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posted to a publicly available website, in whole or in part.
- 7. Common value function functional form
ā Function used often is:
v(z) = zĪ± for zā„0, 0<Ī±<1
v(z) = -Ī»(-z)Ī² for z<0, ļ¬>1, 0<Ī²<1
ā Kink at origin is from Ī».
ā Value function (not utility) so v is used.
ā Ask people about 50/50 coin toss where loss is $50 and gain is
unknown.
ā What gain would make people indifferent between gamble or
no gamble?
ā¢ Many say about $125, which implies value of 2.5 for Ī».
ā¢ Value above one reflects loss aversion.
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posted to a publicly available website, in whole or in part.
- 8. Common ratio effect
ā¢ Prospect pair 4 -- choose between:
ā A: (.9, $2000)
ā B: (.45, $4000)
ā¢ Prospect pair 5 ā choose between:
ā A: (.002, $2000)
ā B: (.001, $4000)
ā¢ Most choose 4A and 5B, but this contradicts
expected utility.
8
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posted to a publicly available website, in whole or in part.
- 9. Common ratio effect cont.
ā¢ Invoke linear transformation rule:
ā Set u(0) = 0 and u(4000) = 1
ā 4A choice implies .9u(2,000) > .45
ā 5B choice implies .002u(2,000) < .001
ā A contradiction
ā¢ How does prospect theory reconcile observed
choices?
ā Nonlinear weighting function can explain these choices
9
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posted to a publicly available website, in whole or in part.
- 10. Lottery tickets
ā¢ Prospect pair 6 -- choose between:
ā A: (.001, $5,000)
ā B: ($5)
ā¢ Most prefer A which is inconsistent with risk
aversion.
ā Lottery effect
ā People seem to overweight low-probability events
(which is why people buy lottery tickets)
10
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posted to a publicly available website, in whole or in part.
- 11. Insurance
ā¢ Prospect pair 7 -- choose between:
ā A: (.001, -$5,000)
ā B: (-$5)
ā¢ Most prefer B which is inconsistent with risk
seeking.
ā Insurance need
ā Once again, people seem to overweight low-
probability events (which is why people buy
insurance)
11
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posted to a publicly available website, in whole or in part.
- 12. Certainty effect
ā¢ Prospect pair 8 -- choose between:
ā A: (.2, $4000)
ā B: (.25, $3000)
ā¢ Prospect pair 9 ā choose between:
ā A: (.8, $4,000)
ā B: ($3000)
ā¢ Most choose 8A and 9B, but they shouldnāt.
ā Use exact same proof as above
ā¢ Why?
ā Certainty is accorded high weight relative to near-certainty
12
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posted to a publicly available website, in whole or in part.
- 14. Weighting function notes
ā¢ Instead of using simple probabilities as in expected utility,
prospect theory uses decision weights, which differ from
probabilities.
ā¢ This (displayed) mathematical function is:
ļ°(pr) = prļ§ / [prļ§ + (1- pr)ļ§](1/ļ§) where ļ§ = .65
ā¢ Weighting function for losses can vary from weighting
function for gains.
ā¢ Low probabilities are given relatively higher weights than
more probable events.
ā¢ And certainty is weighted highly vs. near-certainty.
ā¢ Using functions like this solves some earlier puzzles.
14
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posted to a publicly available website, in whole or in part.
- 15. Valuing prospects under prospect theory
ā¢ Instead of expected utility we have:
V(P) = ļ°(pr A) * v(zA) + ļ°(1 - prA) * v(zB)
ā¢ Steps:
ā Convert probabilities to decision weights
ā Calculate values of wealth differences
ā Use above formula
15
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posted to a publicly available website, in whole or in part.
- 16. Prospects 8 & 9 again
ā¢ Following probabilities are mapped on to this
weighting function:
ā pr = .20; ļ° = .26
ā pr = .25; ļ° = .29
ā pr = .80; ļ° = .64
ā pr = 1; ļ° = 1
ā¢ Say we use v(z) = z1/2.
ā¢ Prospect 8:
ā A: .26*40001/2 = 16.44
ā B: .29*30001/2 = 15.88
ā A is preferred.
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posted to a publicly available website, in whole or in part.
- 17. Prospects 8 & 9 again cont.
ā¢ Prospect 9:
ā A: .64*40001/2 = 40.48
ā B: 1*30001/2 = 54.78
ā B is preferred.
ā A vs. B flip-flop comes from weighting function.
17
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posted to a publicly available website, in whole or in part.
- 18. Frames
ā¢ Essential condition for a theory of choice is
principle of invariance: different
representations of same problem should yield
same preference.
ā¢ Unfortunately this sometimes does not work
out in practice:
ā People have different perspectives and come up
with different decisions depending on how a
problem is framed.
18
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posted to a publicly available website, in whole or in part.
- 19. Some more prospects
ā¢ Prospect pair 10 ā you are given $1000 ā then choose
between:
ā A: (.5, another $1000)
ā B: ($500)
ā¢ Prospect pair 11 ā you are given $2000 ā then choose
between:
ā A: (.5, -$1000)
ā B: (-$500)
ā¢ Results for 10: most prefer B.
ā¢ Results for 11: most prefer A.
ā¢ Problems are identical! People have chosen differently
because of different frames.
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posted to a publicly available website, in whole or in part.
- 20. An odder example
ā¢ You must make two lottery choices. One draw will be in
morning; other in afternoon.
ā¢ Prospect pair 12:
ā A: ($2400)
ā B: (.25, $10,000)
ā¢ Prospect pair 13:
ā A: (-$7500)
ā B: (.75, -$10,000)
ā¢ People prefer 12A and 13B.
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posted to a publicly available website, in whole or in part.
- 21. An odder example cont.
ā¢ But 12A and 13B combo leads:
(.25, $2400, -$7,600)
ā¢ And 12B and 13A combo leads:
(.25, $2500, -$7,500)
ā¢ So people on average choose a gamble that is
dominated by the one that they turn down.
ā¢ Why? They have difficulty getting past frame.
21
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posted to a publicly available website, in whole or in part.
- 22. Mental accounting
ā¢ Related to prospect theory and frames.
ā¢ Accounting is process of categorizing money,
spending and financial events.
ā¢ Mental accounting is a description of way people
intuitively do these things, and how it impacts
financial decision-making.
ā¢ Often tendency to use mental accounting leads to
odd and suboptimal decisions.
ā¢ A few highlights of mental accounting followā¦
22
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posted to a publicly available website, in whole or in part.
- 23. Prospect theory, mental
accounting and prior outcomes
ā¢ Problem with prospect theory is that it was set
up to deal with one-shot gambles ā but what
if there have been prior gains or losses?
ā¢ Do we go back to zero (segregation), or move
along curve (integration)?
23
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posted to a publicly available website, in whole or in part.
- 25. Theater ticket problems
ā¢ 1. Imagine you have decided to see a play where
admission is $10. As you enter theater you discover
that you have lost a $10 bill. Would you still pay $10
for a ticket to the play?
ā¢ 2. Imagine that you have decided to see a play and
paid the admission price of $10 per ticket. As you
enter the theater you discover that you have lost the
ticket. The seat was not marked and the ticket
cannot be recovered. Would you pay $10 for
another ticket?
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posted to a publicly available website, in whole or in part.
- 26. Theater ticket problems cont.
ā¢ Nothing is really different about the problems.
ā¢ Is the ticket worth $10?
ā¢ Of respondents given first question, 88% said they
would buy a ticket.
ā¢ Of respondents given second question, 54% said they
would not buy a ticket.
ā¢ In 2nd question, integration is more likely because
both lost ticket and new ticket would be from same
āaccount.ā
ā Integration might suggest that $20 is too much for the ticket.
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posted to a publicly available website, in whole or in part.
- 27. Opening and closing accounts
ā¢ Once an āaccountā is closed, you go back to
zero.
ā¢ Evidence that people avoid closing accounts at
a loss:
ā Selling a stock at a loss is painful: disposition effect (to be
discussed).
ā Companies rarely have low negative earnings but often have low
positive earnings:
ā¢ They manage earnings either pushing things to low positiveā¦
ā¢ Or they ātake a bathā and move to high negative
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Ā©2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
posted to a publicly available website, in whole or in part.