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Reformulating prospect theory to become a von Neumann–Morgenstern theory

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  • Jack Clark Francis

    (City University of New York (CUNY))

Abstract

This paper reformulates Kahneman–Tversky’s (KT’s) cumulative prospect theory to become a von Neumann–Morgenstern (vNM) theory that is compatible with many existing economic, finance, psychology and decision theories. This vNM theory has the following desirable characteristics: consistently increasing utility of wealth, loss aversion, concave over favorable outcomes, convex over unfavorable outcomes, consistent preference for positively skewed outcomes and it spans the real line between $$ - \infty $$ - ∞ and $$ \infty $$ ∞ . The weighted probabilities in KT’s cumulative prospect theory do not align with the vNM requirement that the probabilities sum to one; nevertheless, important advantages are gained from this vNM assumption.

Suggested Citation

  • Jack Clark Francis, 2021. "Reformulating prospect theory to become a von Neumann–Morgenstern theory," Review of Quantitative Finance and Accounting, Springer, vol. 56(3), pages 965-985, April.
    • Handle: RePEc:kap:rqfnac:v:56:y:2021:i:3:d:10.1007_s11156-020-00915-8
    DOI: 10.1007/s11156-020-00915-8
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