Question

Loughran & Ritter (2002) argue that prospect theory provides an explanation for underpricing. What is prospect theory and how does it advance our knowledge of the IPO market?

Answer 1

Prospect Theory

Prospect theory assumes that losses and gains are valued differently, and thus individuals make decisions based on perceived gains instead of perceived losses. Also known as the "loss-aversion" theory, the general concept is that if two choices are put before an individual, both equal, with one presented in terms of potential gains and the other in terms of possible losses, the former option will be chosen.

How the Prospect Theory Works

Prospect theory belongs to the behavioral economic subgroup, describing how individuals make a choice between probabilistic alternatives where risk is involved and the probability of different outcomes is unknown. This theory was formulated in 1979 and further developed in 1992 by Amos Tversky and Daniel Kahneman, deeming it more psychologically accurate of how decisions are made when compared to the expected utility theory.

The underlying explanation for an individual’s behavior, under prospect theory, is that because the choices are independent and singular, the probability of a gain or a loss is reasonably assumed as being 50/50 instead of the probability that is actually presented. Essentially, the probability of a gain is generally perceived as greater.

versky and Kahneman proposed that losses cause a greater emotional impact on an individual than does an equivalent amount of gain, so given choices presented two ways—with both offering the same result—an individual will pick the option offering perceived gains.

For example, assume that the end result is receiving $25. One option is being given the straight $25. The other option is gaining $50 and losing $25. The utility of the $25 is exactly the same in both options. However, individuals are most likely to choose to receive straight cash because a single gain is generally observed as more favorable than initially having more cash and then suffering a loss.

Types of Prospect Theory

According to Tversky and Kahneman, the certainty effect is exhibited when people prefer certain outcomes and underweight outcomes that are only probable. The certainty effect leads to individuals avoiding risk when there is a prospect of a sure gain. It also contributes to individuals seeking risk when one of their options is a sure loss.

The isolation effect occurs when people have presented two options with the same outcome, but different routes to the outcome. In this case, people are likely to cancel out similar information to lighten the cognitive load, and their conclusions will vary depending on how the options are framed.

Prospect Theory Example

Consider an investor is given a pitch for the same mutual fund by two separate financial advisors. One advisor presents the fund to the investor, highlighting that it has an average return of 12% over the past three years. The other advisor tells the investor that the fund has had above-average returns in the past 10 years, but in recent years it has been declining. Prospect theory assumes that though the investor was presented with the exact same mutual fund, he is likely to buy the fund from the first advisor, who expressed the fund’s rate of return as an overall gain instead of the advisor presenting the fund as having high returns and losses.