Investor Preferences

Question 1

What is the prospect theory?

Answer 1

A critique of EUT as a descriptive model of decision making under risk

Question 2

What are the main points of prospect theory? 7

Answer 2

• changes in wealth matter, not the final state
• reference point matters:people react differently to risk depending on whether the outcome is a gain or loss
• loss aversion:people are more averse to loss than attracted to gain
• S shaped value function :convex for losses and concave for gains
• uses a function that overweight low probabilities and under weighs high probabilities
• steeper in loss that gain
• reflection effect:value function is Steele near the point of reference (the first gain/loss)

Question 3

What is mental accounting?

Answer 3

It’s not about the absolute size of savings, but the relative proportion of savings

Question 4

What are the 3 types of mental accounting?

Answer 4

• minimal:only cares about the value of savings
• topical:considers the context in which the decision arises
• comprehensive:looks at all details and monthly expense (rational)

Question 5

What are the arguments of mental accounting?

Answer 5

Moon Keasey and Duxbury

• Threshold effect:mental accounting effects disappear as the level of absolute savings increase
• mental accounting effects don’t hold in the reverse condition(prefer money over time)

Question 6

What are the violations of the expected utility theory? 4

Answer 6

• allais paradox/ellsberg’s paradox
• failure of dominance
• failure of invariance
• framing effect:people make their choices based in the way the question is framed