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Behavioural FinanceWeek 3
Monday & Wednesday: B&M CH. 5 + Rabin & Thaler, 2001 + Kahneman & Tversky, 1979
Chapter 5: Framing and the reversal of preferences
Expected-utility theory: Each level of an outcome is associated with an expected degree of
pleasure or net benefit, called utility (replaces criterion of expected monetary value).
Declining marginal utility of gains: The more we get of something, the less pleasure it
provides us.
Individuals treats risk concerning perceived gains differently from risks concerning perceived
losses.
Kahnman and Tversky’s prospect theory even perceived differences based on the change
in the ‘framing’ of choices can dramatically affect how people make decisions.
Framing: The alternative wordings of the same objective information that significantly alter
the decisions that people typically make, even though differences between framing should
have no effect on the rational decision.
Typical decision makers evaluate outcomes relative to a neutral reference point. The
location of the reference point has a critical effect on whether the decision is positively or
negatively framed and affects the resulting risk preference.
Framing and the irrationality of the sum of our choices: Sometimes individual decision
seems sensible, but when viewed as a whole obviously suboptimal. By being risk averse at
the one time and risk seeking at the other moment, bad decision portfolio
We like certainty, even pseudo certainty: People underweight high-probability events but
appropriately weight evens that are certain. People value certainty over an equally valued
shift in the level of uncertainty. Full protection framing provides ‘pseudo certainty’.
Rationally, any constant reduction in risk should have the same value for the decision
maker.
Certainty effect = A reduction of the probability of an outcome has more importance when
the outcome was initially certain than when it was merely probable.
Framing and overselling of insurance: Describing a sure loss as an insurance premium makes
the loss more attractive, even when the objective amount of loss is the same.
What’s it worth to you: Purchases are affected by acquisition and transactional utility.
Acquisition utilities describe the value you place on a commodity (beer). Transactional utility
,refers to the quality of the deal that you receive, evaluated in reference to ‘what the item
should cost’.
The value we place on what we own: Endowment effect = Most people would demand far
more to sell their panting than they would be willing to pay for the exact painting if they did
not own it.
Rebate/bonus framing: When something is framed as a bonus (spending) people will tend to
expense the money and when it is framed as rebate (saving) they will keep the money for
themselves.
Joint-versus-separate preference reversals: Inconsistency in preferences across joint vs.
separate evaluations.
Evaluability hypothesis = Separate vs. joint reversals are driven by differences in the ability
of attributes to be evaluated.
Article 3: Risk aversion (Rabin & Thaler, 2001)
The assumption of the expected utility theory that attitudes toward medium and large risks
arise from the same utility function relates to a much-discussed implication of the theory:
that people have roughly the same risk attitude towards an aggregation of independent,
identical gambling for each of the independent gambling.
It was shown that a pair of choices was inconsistent with expected utility theory, which
implies that if (for some range of wealth levels) a person turns down a particular gamble,
then the person should also turn down an offer to play many of those gambles.
What does explain the modest-scale risk aversion?
- Loss aversion – Tendency to feel the pain of a loss more acutely than the pleasure of
an equal-sized gain.
- Mental accounting – Small-scale risk aversion seems to derive from the tendency to
assess risks in isolation rather than in broader perspective. If small-scale better-than-
fair gambles were evaluated in broader perspective, people would be more likely to
accept them. They would realize that by taking a series of such bets, the gains would
tend to outweigh the losses in the long run. Moreover, when incorporated with their
other wealth, the stakes of the bet would seem small.
Decision isolation, narrow framing, narrow bracketing, myopic loss aversion = tendency to
take problems one at a time. Can explain many phenomena that expected utility theory
cannot.
Article 4: Prospect Theory: An Analysis of Decision under Risk (Kahneman & Tversky, 1979)
Expected utility theory:
- Expectation (overall utility of a prospect)
- Asset integration (utility of integrating the prospect with one’s assets exceeds the
utility of those assets alone)
- Risk aversion (if x is preferred to any risk prospect with expected value x
,Empirical effects which invalidate the expected utility theory:
Certainty effect (Risk aversion)
People overweight outcomes that are considered certain, relative to probable
outcomes
Reflection effects
The certainty effect mirrored, and proposed in terms of losses instead of gains (risk
seeking)
Probabilistic insurance
One pays certain cost to reduce probability of undesirable event, without eliminating
it altogether
Isolation effect
People simplify choices by disregarding components that alternatives share.
Two phases of prospect theory (alternative account of individual decision making under risk)
1) Phase of editing – Preliminary analysis of the offered prospects
2) Phase of evaluation
In prospect theory, the value of each outcome is multiplied by a decision weight, inferred
from choices between prospects. Measure the impact of events on the desirability of
prospects and not merely on the perceived likelihood of these events
Definition of:
Prospect theory: The preference of decisions in uncertainty depends on the circumstances.
For example, the estimate of opportunities and risks is not absolute, but relative to the
previous situation.
Expected utility theory: An approach to determine the expected economic benefit of a
decision in the case of uncertain outcomes.
Difference between the two: Expected Utility theory assumes individuals will choose the
outcome which gives maximum utility given the probability of outcomes. Prospect theory
allows for the fact that individuals may choose a decision which doesn't necessarily
maximize utility because they place other considerations above utility
Monday: Lecture 5 – Expected Utility Theory
No behavioral theory but benchmark model for how people make choices in uncertainty.
Show how normative model fails to explain how we really make decisions on risk
The Preferences of the Homo Economicus
- Obeys the principles of Expected Utility Theory
How much are you willing to pay?
Consider the following game:
A coin flipped. If the coin lands…
Heads you receive 10,-
Tails you receive nothing
, What is the largest amount you are willing to pay to play this game?
5,- is the expected value of the game. In expectation you win 5,-.
Consider another game:
A coin is flipped repeatedly. Your initial payoff is 1,-
If the coin lands…
Heads you receive the potential payoff and the game ends
Tails the potential is doubled and the coin is flipped again
Q: What is the largest amount you are willing to pay to play this game?
St. Petersburg Paradox (1713)
The expected value of this game:
(1/2 x 1,-)+(1/4 x 2,-)+(1/8 x 4,-)+….
= 0,50 + 0,50 + 0,50 + 0,50 = infinite
Would you give up your 10,000 savings account to play…?
For a 7/8 of giving you less than 5,- in return
And a 99% probability of giving you less than 50,- in return
A risk neutral person would!
People are not using the expected value criterion
Daniel Bernoulli (1738): People have risk-averse preferences. People maximize expected
utility, not expected monetary value.
Utility is not linear in monetary payoffs = Diminishing Marginal Utility
The same amount of additional money is less useful to an already-wealthy person than it
would be to a poor person (Bernouilli).
People derive ‘diminishing marginal utility’ from money
Why is the St. Petersburg Paradox a significant concept in the area of decision making?
Linear utility function (theory, but not the Decreasing marginal utility, represents a
case) logarithm function (non-linear utility
function). Utility of wealth is on the vertical
axis
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