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A Satiscing Alternative to Prospect Theory

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Author Info

  • David B. BROWN

    (Fuqua School of Business, Duke University)

  • Enrico G. DE GIORGI

    (University of St. Gallen, Swiss Finance Institute and University of Lugano)

  • Melvyn SIM

    (NUS Business School, NUS Risk Management Institute, National University of Singapore)

Abstract

In this paper, we axiomatize a target-based model of choice that allows decision makers to be both risk averse and risk seeking, depending on the payoff's position relative to a pre- specified target. The approach can be viewed as a hybrid model, capturing in spirit two celebrated ideas: first, the satisficing concept of Simon (1955); second, the switch between risk aversion and risk seeking popularized by the prospect theory of Kahneman and Tversky (1979). Our axioms are simple and intuitive; in order to be implemented in practice, our approach requires only the specification of an aspiration level. We show that this approach is dual to a known approach using risk measures, thereby allowing us to connect to existing theory. Though our approach is intended to be normative, we also show that it resolves the classical paradoxes of Allais (1953) and Ellsberg (1961), neither of which can be explained by expected utility theory.

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Bibliographic Info

Paper provided by Swiss Finance Institute in its series Swiss Finance Institute Research Paper Series with number 09-19.

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Length: 63 pages
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Handle: RePEc:chf:rpseri:rp0919

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Web page: http://www.SwissFinanceInstitute.ch
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Related research

Keywords: satisficing; aspiration levels; targets; prospect theory; reflection effect; risk measures; convex risk measures; portfolio optimization.;

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References

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  1. R. Rockafellar & Stan Uryasev & Michael Zabarankin, 2006. "Generalized deviations in risk analysis," Finance and Stochastics, Springer, vol. 10(1), pages 51-74, 01.
  2. De Giorgi, Enrico, 2005. "Reward-risk portfolio selection and stochastic dominance," Journal of Banking & Finance, Elsevier, vol. 29(4), pages 895-926, April.
  3. Milton Friedman & L. J. Savage, 1948. "The Utility Analysis of Choices Involving Risk," Journal of Political Economy, University of Chicago Press, vol. 56, pages 279.
  4. Machina, Mark J, 1982. ""Expected Utility" Analysis without the Independence Axiom," Econometrica, Econometric Society, vol. 50(2), pages 277-323, March.
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  8. David B. Brown & Melvyn Sim, 2009. "Satisficing Measures for Analysis of Risky Positions," Management Science, INFORMS, vol. 55(1), pages 71-84, January.
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  18. Philippe Artzner & Freddy Delbaen & Jean-Marc Eber & David Heath, 1999. "Coherent Measures of Risk," Mathematical Finance, Wiley Blackwell, vol. 9(3), pages 203-228.
  19. John W. Payne & Dan J. Laughhunn & Roy Crum, 1980. "Translation of Gambles and Aspiration Level Effects in Risky Choice Behavior," Management Science, INFORMS, vol. 26(10), pages 1039-1060, October.
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Cited by:
  1. Enrico G. De Giorgi, 2009. "Goal-Based Investing with Cumulative Prospect Theory and Satisficing Behavior," University of St. Gallen Department of Economics working paper series 2009 2009-22, Department of Economics, University of St. Gallen.

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