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Can prospect theory be used to predict an investor’s willingness to pay?

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  • Erner, Carsten
  • Klos, Alexander
  • Langer, Thomas

Abstract

Cumulative prospect theory (CPT) is widely considered to be the most successful descriptive theory for decision making under risk and uncertainty. Sophisticated methods have been developed to reliably elicit CPT parameters on an individual basis. The aim of this paper is to analyze whether such methods are suited to be applied in real world situations, particularly in the context of investment counseling for retail investors. Specifically, we examine whether CPT parameters elicited via standardized computer tools are successful in predicting an individual’s preference for different structured financial products. Surprisingly, we find only low predictive power of the elicited CPT parameters on the WTP. Using a second set of experiments, we examine possible explanations for the low prediction quality. Overall, we have to conclude that it is too much of a leap to draw conclusions about the attractiveness of complex financial products from CPT parameters elicited via simple lotteries.

Suggested Citation

  • Erner, Carsten & Klos, Alexander & Langer, Thomas, 2013. "Can prospect theory be used to predict an investor’s willingness to pay?," Journal of Banking & Finance, Elsevier, vol. 37(6), pages 1960-1973.
  • Handle: RePEc:eee:jbfina:v:37:y:2013:i:6:p:1960-1973
    DOI: 10.1016/j.jbankfin.2012.12.008
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    References listed on IDEAS

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    Cited by:

    1. repec:oup:ecpoli:v:32:y:2017:i:92:p:757-809. is not listed on IDEAS
    2. Silvio Aldrovandi & Petko Kusev & Tetiana Hill & Ivo Vlaev, 2017. "Context Moderates Priming Effects on Financial Risk Taking," Risks, MDPI, Open Access Journal, vol. 5(1), pages 1-11, March.

    More about this item

    Keywords

    Cumulative prospect theory; Preference elicitation; Retail investor; Behavioral finance; Structured financial product;

    JEL classification:

    • C91 - Mathematical and Quantitative Methods - - Design of Experiments - - - Laboratory, Individual Behavior
    • D11 - Microeconomics - - Household Behavior - - - Consumer Economics: Theory
    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • G20 - Financial Economics - - Financial Institutions and Services - - - General

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