Expected Utility and Prospect Theory (Chapter 6)

Question 1

What are the two concepts of happiness? How do they differ?

Answer 1

1. Life evaluation - Sustained happiness:
   -> all benefits of wealth (utilitarian, expressive & emotional), rise steadily with income
   -> = Expected utility theory
2. Experienced happiness - Fleeting happiness:
   -> emotional well-being, questions about yesterday, does not rise beyond an income of 75.000 Dollar
   -> = Prospect theory

Question 2

What are the important differences between expected-utility theory and prospect theory?

Answer 2

Expected-utility theory:
-utility is wealth utility
-wealth utility is sustained happiness or life evaluation
-predicts that sustained happiness from wealth is high when wealth is high
-choices are made by considering the effects of outcomes on total wealth, people prefer high wealth over low wealth
-choices reflect risk aversion, never to risk seeking when risk is measured by variance of returns (sd)
-emotions play no role in choices

Propect theory:
-utility is gain-loss utility
-gain-loss utility is fleeting happiness or experienced happiness
-experienced happiness today is influenced by gains or losses from yesterday
-choices are made by considering the effects of outcomes on gains and losses, people prefer high gains over low gains or losses
-choices reflect risk aversion
-emotions play role in choices, especially hope, fear, pride & regret

Question 3

What is the difference in variance aversion and loss aversion in EUT and PT?

Answer 3

EUT: choices correspond to risk aversion, never risk seeking when risk is measured by variance of returns

PT: choices correspond to risk aversion, when risk is variance aversion, loss aversion or shortfall aversion

-> some PT choices conform to variance aversion, consistent with expected-utility theory, other choices conform to variance seeking, consistent with shortfall aversion in PT, but inconsistent with EUT

Question 4

What is loss aversion in PT?

Answer 4

=pain of losses is greater than pleasure of gains in equal magnitude

Loss aversion reflected in PT functiion that declines by more in the domain of losses than it increases in domain of gains in range close to reference point

Question 5

What is shortfall aversion?

Answer 5

=tendency of indidividuals to be more sensitive to the possibility of falling short of their financial goals (aspiration level) than to the possibility of exceeding them.

-> lead to more conservative investment strategies that have lower risk of losses, even if those strategies also have lower potential for gains

E.g. people will prefer a gamble of 50-50 chance of 0$ and -15,000$ over a sure 5,000$ loss

Question 6

Whats the difference between loss aversion and shortfall aversion?

Answer 6

Shortfall aversion is concerned with the fear of falling short of a financial goal, while loss aversion is concerned with the emotional pain of a loss itself.

Question 7

What are probability weights?

Answer 7

=ratios of subjective probabilities to objective probabilities (of possible outcomes)

Probability weights equal 1 = subjective = objective
-> when free of making errors and consider only utilitarian costs and benefits

Probability weights depart from 1
-> even when free of making errors when also considering aspirations, expressive and emotional costs and benefits (e.g. hope and fear)

Question 8

How do probability weights differ in EUT and PT?

Answer 8

EUT: people use objective probabilities of possible outcomes as they consider choices

PT: people use probabilities that can depart from objective probabilities

Question 9

How do probability weights look like in shortfall aversion?

Answer 9

Aversion to shortfall from aspiration + hope for reaching it prompts assigning much higher subjective probability than objective probability indicates

Probability weights can overcome objective probabilities in terms of aspiration to avoid shortfall, heightened by e.g. the anticipated emotional cost of regret, emotional benefit of hope, cost of fear

Question 10

What are the reference points in loss aversion and shortfall aversion?

Answer 10

Loss aversion -> status quo of current wealth
Shortfall aversion -> aspiration level higher than current position

Question 11

What are the characteristics of the EUT function?

Answer 11

1. Utility is wealth utility: Life evaluation / sustained happiness derived from wealth
2. Wealth utility increases slower than wealth
3. People prefer high wealth over low wealth
4. The scale of wealth utility is arbitrary.

Question 12

What is variance aversion?

Answer 12

=”We don’t like volatile outcomes.”

-> occurs in both EUT and PT