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Prospect Theory: Much Ado About Nothing?

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Author Info

  • Moshe Levy

    () (Hebrew University of Jerusalem, Jerusalem, 91905, Israel)

  • Haim Levy

    () (Hebrew University of Jerusalem, Jerusalem, 91905, Israel)

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    Abstract

    Prospect theory is a paradigm challenging the expected utility paradigm. One of the fundamental components of prospect theory is the S-shaped value function. The value function is mainly justified by experimental investigation of the certainty equivalents of prospects confined either to the negative or to the positive domain, but not of mixed prospects, which characterize most actual investments. We conduct an experimental study with mixed prospects, using, for the first time, recently developed investment criteria called Prospect Stochastic Dominance (PSD) and Markowitz Stochastic Dominance (MSD). We reject the S-shaped value function, showing that at least 62%--76% of the subjects cannot be characterized by such preferences. We find support for the Markowitz utility function, which is a reversed S-shaped function---exactly the opposite of the prospect theory value function. It is possible that the previous results supporting the S-shaped value function are distorted because the prospects had only positive or only negative outcomes, presenting hypothetical situations which individuals do not usually face, and which are certainly not common in financial markets.

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    File URL: http://dx.doi.org/10.1287/mnsc.48.10.1334.276
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    Bibliographic Info

    Article provided by INFORMS in its journal Management Science.

    Volume (Year): 48 (2002)
    Issue (Month): 10 (October)
    Pages: 1334-1349

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    Handle: RePEc:inm:ormnsc:v:48:y:2002:i:10:p:1334-1349

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    Related research

    Keywords: prospect theory; prospect stochastic dominance; markowitz stochastic dominance;

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    Citations

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    Cited by:
    1. Antoni Bosch-Domènech & Joaquim Silvestre, 2006. "Averting risk in the face of large losses: Bernoulli vs. Tversky and Kahneman," Economics Working Papers 932, Department of Economics and Business, Universitat Pompeu Fabra.
    2. Hooi Hooi Lean & Michael McAleer & Wing-Keung Wong, 2010. "Market Efficiency of Oil Spot and Futures: A Mean-Variance and Stochastic Dominance Approach," Working Papers in Economics 10/18, University of Canterbury, Department of Economics and Finance.
    3. Anderson, Anders E. S., 2004. "One for the Gain, Three for the Loss," SIFR Research Report Series 20, Institute for Financial Research.
    4. Haim Levy, 2004. "Prospect Theory and Mean-Variance Analysis," Review of Financial Studies, Society for Financial Studies, vol. 17(4), pages 1015-1041.
    5. Michael Birnbaum, 2005. "A Comparison of Five Models that Predict Violations of First-Order Stochastic Dominance in Risky Decision Making," Journal of Risk and Uncertainty, Springer, vol. 31(3), pages 263-287, December.
    6. Baucells, Manel & Heukamp, Franz H., 2004. "Reevaluation of the results of Levy and Levy (2002a)," Organizational Behavior and Human Decision Processes, Elsevier, vol. 94(1), pages 15-21, May.
    7. Birnbaum, Michael H., 2004. "Tests of rank-dependent utility and cumulative prospect theory in gambles represented by natural frequencies: Effects of format, event framing, and branch splitting," Organizational Behavior and Human Decision Processes, Elsevier, vol. 95(1), pages 40-65, September.
    8. Wong, Wing-Keung, 2007. "Stochastic dominance and mean-variance measures of profit and loss for business planning and investment," European Journal of Operational Research, Elsevier, vol. 182(2), pages 829-843, October.
    9. Rosenblatt-Wisch, Rina, 2008. "Loss aversion in aggregate macroeconomic time series," European Economic Review, Elsevier, vol. 52(7), pages 1140-1159, October.
    10. Sergio Ortobelli & Svetlozar Rachev & Haim Shalit & Frank Fabozzi, 2009. "Orderings and Probability Functionals Consistent with Preferences," Applied Mathematical Finance, Taylor and Francis Journals, vol. 16(1), pages 81-102.
    11. Zhang, Duo, 2008. "Non-convex optimal portfolio sets and constant relative risk aversion," Journal of Economics and Business, Elsevier, vol. 60(6), pages 551-555.
    12. Levy, Moshe, 2005. "Is risk-aversion hereditary?," Journal of Mathematical Economics, Elsevier, vol. 41(1-2), pages 157-168, February.
    13. Christiane Ernst & Christian Thöni, 2009. "Bimodal Bidding in Experimental All-Pay Auctions," University of St. Gallen Department of Economics working paper series 2009 2009-25, Department of Economics, University of St. Gallen.
    14. Carole Bernard & Jit Seng Chen & Steven Vanduffel, 2013. "All investors are risk averse expected utility maximizers," Papers 1302.4679, arXiv.org.
    15. Chan, Raymond H. & Clark, Ephraim & Wong, Wing-Keung, 2012. "On the Third Order Stochastic Dominance for Risk-Averse and Risk-Seeking Investors," MPRA Paper 42676, University Library of Munich, Germany.
    16. Schwanen, Tim & Ettema, Dick, 2009. "Coping with unreliable transportation when collecting children: Examining parents' behavior with cumulative prospect theory," Transportation Research Part A: Policy and Practice, Elsevier, vol. 43(5), pages 511-525, June.
    17. Sandri, Serena & Schade, Christian & Musshoff, Oliver & Odening, Martin, 2010. "Holding on for too long? An experimental study on inertia in entrepreneurs’ and non-entrepreneurs’ disinvestment choices," Structural Change in Agriculture/Strukturwandel im Agrarsektor (SiAg) Working Papers 59518, Humboldt University Berlin, Department of Agricultural Economics.
    18. Basili, Marcello & Chateauneuf, Alain & Fontini, Fulvio, 2008. "Precautionary principle as a rule of choice with optimism on windfall gains and pessimism on catastrophic losses," Ecological Economics, Elsevier, vol. 67(3), pages 485-491, October.

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