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Prospect Theory: Much Ado About Nothing?

Author Info

Listed author(s):
  • Moshe Levy

    ()

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

  • Haim Levy

    ()

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

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

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  1. Yaari, Menahem E, 1987. "The Dual Theory of Choice under Risk," Econometrica, Econometric Society, vol. 55(1), pages 95-115, January.
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  17. Milton Friedman & L. J. Savage, 1948. "The Utility Analysis of Choices Involving Risk," Journal of Political Economy, University of Chicago Press, vol. 56, pages 279-279.
  18. Levy, Haim & Wiener, Zvi, 1998. "Stochastic Dominance and Prospect Dominance with Subjective Weighting Functions," Journal of Risk and Uncertainty, Springer, vol. 16(2), pages 147-163, May-June.
  19. Nicholas Barberis & Ming Huang & Tano Santos, 2001. "Prospect Theory and Asset Prices," The Quarterly Journal of Economics, Oxford University Press, vol. 116(1), pages 1-53.
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