3 - Prospect Theory Flashcards
What is prospect theory?
Prospect theory is an alternative to expected utility theory inspired by demonstrated violations of expected utility theory. It accounts for the observations that people sometimes exhibit risk aversion and sometimes exhibit risk seeking, depending on the nature of the prospect. The value function in prospect theory replaces the utility function in expected utility theory. While utility is usually measured in terms of the level of wealth, value is defined by gains and losses relative to a reference point.
What is loss aversion?
The tendency for losses to loom larger than equivalent gains.
What is the endowment effect?
It is an example of riskless loss aversion. It is the tendency to value a good more when owned. Losses (giving up the good) are felt much more strongly than gains (receiving the good).
What is the house money effect?
People treat money won at gambling or profit earned from investments as free money rather than a gain. They are often risk-seeking (or less risk-averse) with house money. They bet more aggressively or make higher risk investments. Initial capital is kept separate from recent profit which is seen as disposable.
What is the break-even effect?
When faced with losses people tend to be risk seeking. They will be willing to take bigger gambles to win back losses than they will to simply reduce them (try get losses back or cut their losses).
What is the disposition effect?
An effect of loss aversion. It is the tendency to avoid selling losing positions (e.g., stocks going down in value).
What is integration (in context of mental accounting)?
Integration occurs when positions are lumped together. For example, imagine a better has lost $150 and considers one more bet of $10 with 15:1 odds. He is integrating if he views the last bet as a chance to break even. Viewing it this way would result in behaviour that is more risk-seeking.
What is segregation (in context of mental accounting)?
Segregation occurs when situations are viewed one at a time. For example, if a better has lost $150 but views the outcome of one final bet independently, as either a very unlikely gain of $150 or a very likely loss of $10, he is segregating, not allowing previous gains or losses to influence his decision. In the context of prospect theory, segregation can be considered taking the individual back to the original reference point before viewing the new situation (i.e., not considering change in wealth from previous event when evaluating new one).
