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example outline - Camerer, C. Prospect Theory in the Wild....

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Camerer, C. Prospect Theory in the Wild. Expected Utility : gambles with risky outcomes, xi, with probabilities, pi, are valued by Σ p i u(x i ) Prospect Theory : gambles are valued by Σ Π p i v(x i -r); (p) –weights probabilities nonlinearly, overweighting small probabilities and underweighting larger ones Reflection effect diminishing marginal sensitivity to movement from the reference point, r such that v(x-r) is concave for losses; convex for gains. Loss aversion -v(-x) > v(x) for x>0 Bottom-line: Prospect Theory—through loss aversion , reflection effects , and nonlinear weighting of probabilities -- can explain at least 10 expected utility theory anomalies that regularly occur “in the wild” 10 Anomalies and brief explanations : 1) Finance: The Equity Premium excess return that you can expect from the overall market above a risk-free return, which is approx. 8% higher for stocks than bonds. Why the excessive risk aversion towards stocks? If people have a loss aversion coefficient of 2.25, and if computing expected values over a short horizon, the approx. value of stocks and bonds are equal with a stock return of 8% more. 2) Finance: The Disposition Effect investors hold on to losing stocks (relative to purchase price) and sell rising stocks. Purchase price shouldn’t matter, though—one should sell losing and
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This note was uploaded on 02/24/2011 for the course ECO 3933 taught by Professor Hamman during the Spring '11 term at FSU.

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example outline - Camerer, C. Prospect Theory in the Wild....

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