Question

Behavioral finance is an important component in making investment decisions. This weeks work hopefully hi-lighted its importance.  Prospect theory and its originators, Daniel Kahneman and Amos Tversky, have made a significant contribution to the investment decision process. For your second assignment, a 500-700 word paper on Prospect Theory is requested. This paper will be 5% of your final grade. It is due March 10 at 11:59PM. The paper should be address the following:

1. A brief description of Kahneman and Tversky  (10% of grade)

2. Attaining the 500 minimum word requirement (20% of grade)

3. The importance of this break through work. (30% of grade)
4. How it applies to stock market decisions. (40% of grade)

Answer 1

Cognitive psychologists Daniel Kahneman and Amos Tversky are referred to as the fathers of behavioral finance. Since the beginning of their collaboration in the late 1960s they have published around 200 works, and their main focus are the cognitive biases and problem solving methods that cause people to behave irrationally. Their most popular writings handles the topics prospect theory and loss aversion.

Prospect theory is an important theory for decision-making between alternatives that involve risk. The theory departs from the traditional expected utility theory because it attempts to explain how people really make decisions between risky alternatives, which attempts to model optimal decisions. This vital difference leads to the prospect theory departing from the traditional framework in important ways. Unlike the traditional approach, it attempts to incorporate psychology into the consideration process to provide a behavioural approach to portfolio selection

There are four key features of Prospect Theory

First, according to the traditional theory people choose among alternatives based on how the outcomes will affect their overall wealth. However, according to prospect theory people evaluate outcomes in terms of gains and losses relative to a reference point. So decisions are based on how the outcome changes their income, in relation to their reference point.

Second, the mean variance analysis makes the assumption that people are risk averse in all their choices. In contrast, prospect theory agents are risk-averse in the domain of gains but are risk seeking when all changes in income are framed as losses.

The third feature of prospect theory is “loss aversion.” An individual is loss averse if she or he dislikes symmetric 50-50 bets and their degree of aversion increases with the absolute size of the stakes. In other words, prospect agents don’t perceive gains and losses of equal amounts evenly. For example, the loss of a particular amount is more painful than the pleasure received from the gain of an equal amount. This is also known as the endowment affect. People place a higher value on a good that they own than goods that they do not, and are willing to accept a higher risk if it means that they can avoid the loss.

Finally, in utility theory risk is treated objectively, by its probabilities. In contrast, the utility under prospect theory is not dependant on the original probability but rather on the transformed probability also known as decision weights. “They do not just measure the perceived likelihood of an event. Instead, they measure how events will impact the desirability of prospects.”

The disposition effect is the tendency that investors have to hold on to losing stocks for too long and to sell winning stocks too soon. Prospect theory is useful in explaining this phenomenon as well. The logical course of action would be to do the opposite: to hold on to winning stocks in order to further gains, while selling losing stocks in order to prevent additional losses.

The example of investors who sell winning stocks prematurely can be explained by Kahneman and Tversky’s study, in which individuals settled for a lower guaranteed gain of $500 as compared with a riskier option that could either yield a gain of $1,000 or $0. Both subjects in the study and investors who hold winning stocks in the real world are overeager to cash in on the gains that have already been guaranteed. They are unwilling to take a risk to earn larger gains. This is an example of typical risk-averse behavior.