Prospect Theory by Kahnemann & Tversky (1979)

Question 1

What is meant by the certainty effect in EUT and PT? What is the problem with the certainty effect?

Answer 1

Utilities of outcomes are weighted by their probabilities.

Issue: People overweight outcomes that are considered certain, relative to outcomes which are merely probable = certainty effect

PT: If winning is possible but not probable, most choose prospect offering larger gain, e.g. people prefer prospects that are certain over prospects that have f.e. an 50% chance but the same expected value.

Question 2

What is meant by the reflection effect? What does it imply? How is the certainty effect related to the reflection effect?

Answer 2

What happens when the signs of the outcomes are reversed so that gains are replaced by losses?
-> the reflection of prospects around 0 reverses the preference order = reflection effect

Due to certainty effect: certainty increases the aversiveness of losses as well as the desirability of gain.

This implies that risk aversion in the positive domain is accompanied by risk seeking in the negative domain.
-> in the positive domain, the certainty effect contributes to a risk averse preference for a sure gain over a larger gain that is merely probable
-> in the negative domain, the certainty effect leads to a risk seeking preference for a loss that is merely probable over a smaller loss that is certain

Question 3

What are the 4 main critiques of EUT by Kahnemann & Tversky?

Answer 3

1. The Certainty Effect
2. The Reflection Effect
3. The Probabilistic Insurance
4. The Isolation Effect

Question 4

What is the “Probabilistic Insurance”? How is EUT and PT related?

Answer 4

In this program you pay half of the regular premium.
-> in case of damage, there is a 50% chance that you pay the other half of the premium and the insurance company covers all the losses
-> there is another 50% that you get back your insurance payment and suffer all losses

In PT: Probabilistic insurance is generally unattractive (appears intuitively riskier)
In EUT: Probabilistic insurance is superior to regular insurance

Question 5

What is the isolation effect?

Answer 5

In order to simplify the choice between alternatives, people disregard components that the alternatives share; instead, they focus on components that distinguish them.

e.g. People ignore first part of game since they are the same for both prospects.

In EUT: the same utility is assigned to wealth of 100k, regardless if it was reached from a prior wealth of 95k or 105k.
-> implies that carrier of value or utility are changes of wealth, rather than final asset positions that include current wealth (cornerstone of prospect theory)

In the context of investing, the isolation effect can lead investors to make decisions based on a single piece of information, rather than taking into account the larger context.

Question 6

In this paper, two functions are used to describe PT? What are they about?

Answer 6

1. The value function = gain-loss function (steeper loss domain curve)
   -the carriers of value are the delta in wealth or welfare rather than final states
   -both asset position as reference point and magnitude of delta are important
2. The weighting function
   -in PT, the value of each outcome is multiplied by a decision weight
   -decision weights are inferred from choices between prospects and from subjective probabilities
   -decision weight = a person’s subjective interpretation of an objective probability

Question 7

What do the authors propose regarding the outcomes of the weighting function?

Answer 7

1. very low probabilities are generally overweighted
2. people prefer a small loss over a small probability of a large loss
3. overestimation and overweighting may both operate to increase the impact of rare events

Question 8

Specify the value function characteristics in PT.

Answer 8

The value function is…
…defined on deviations from the reference point
…generally concave for gains and commonly convex for losses
…steeper for losses than for gains
…steepest at the reference point, in marked contrast to the utility function

Question 9

When can a shift of the reference point occur?

Answer 9

1. Gains and losses are coded relative to an expectation or aspiration level that differs from the status quo.
2. Recent changes in wealth to which one has not yet adapted.
3. Person formulates his decision problem in terms of final assets rather in terms of gains and losses as people usually do. The reference point is set to zero.

Question 10

What are the properties of PT?

Answer 10

1. Loss aversion: losses loom larger than gains.
2. Evaluation is relative: to your current reference point
3. Diminishing sensitivity: people are risk averse in relation to gains (e.g. prefer certainty) but risk seeking in relation to losses