Financial Decisions Under Risk: A Study of Revealed Preferences

University of Athens
Doctoral Program in Economics

Department of Economic Sciences
PhD Thesis
“Financial Decisions Facing Risk”
Submitted by
Katerina Mita
Supervising Committee:
Professor Panagiotis Alexakis

Professor Dimitris Moschos
Assistant Professor Yiannis Bassiakos
Athens, June 2013

Abstract
The theoretical foundations of economic theory on financial decisions facing risk

depend on revealed preferences. This thesis analyses the relationship between
the level of the payouts and risk appetite, and reveals a significant interaction.
The assumption that revealed preference based on contingent valuations can
lead to inflated risk aversion assumptions in empirical research is verified.
Moreover, this analysis introduces the innovative technique of sequential
equivalence that can reduce the endowment effect. Finally, building on the
principle of reference dependence a loss aversion-adjusted measure of risk
aversion (LARA) can accommodate the asymmetric significance of gains and
losses in the perception of financial risk.
The data used in this analysis is drawn from the revealed preferences of
experienced investors faced with risky prospects, extracted using simple ranking
and valuation tasks such as the ordering of lotteries by attractiveness and the
pricing of lottery tickets. The recorded disparity between WTP and WTA
documents a profound relationship between risk appetite and the subjective
significance of the payout amounts. However, this disparity is consistently
exaggerated in both ranking and valuation tasks, and is not susceptible to
significant preference reversals. The disparity and the theoretical deviations it
incorporates can be reduced using simple procedural interventions. To that
effect, the introduction of the innovative technique of Sequential Equivalence
(SE) reduces some valuation anomalies, building on the framing effect to
effectively “correct” certainty equivalent approximations. Furthermore, while the
existence of loss aversion is confirmed, its impact is reduced in SE valuation
tasks. In other words, the proposed new approach to the concept of loss aversion
which departs from the narrow definition of aversion for losses, and focuses on
the relative significance of the outcomes.
Finally, this analysis exemplifies the effects of framing and its impact on financial
decision making. In fact it is precisely the framing effect that is used to confirm
and correct valuation prices, which in turn produce a more accurate assessment
of individual risk profiles. The improved approximation of WTA through the
sequential WTP (SWTP) indicates the importance of the asymmetric significance
of amounts. By extension, this thesis concludes with the assumption that the
reason for the discrepancy lies with the fact that decision makers do not
necessarily evaluate amounts or utilities of amounts, but rather significance
levels around a reference point.
i
Page Intentionally Left Blank
ii
Table of Contents
List of Tables ............................................................................................................................................ iv
List of Figures ........................................................................................................................................... v
Acknowledgements .............................................................................................................................. vi
Chapter 1 - Introduction ..................................................................................................................... 1
Chapter 2 - Key Concepts in Financial Decision Making .................................................. 12
2.1 Some Definitions ............................................................................................................... 12
2.2 Lotteries as Risky Prospects ........................................................................................ 20
2.3 Risk Aversion ...................................................................................................................... 23
Chapter 3 - Theories of Risk and Financial Decisions........................................................ 27
3.1 Normative vs Descriptive Theories .......................................................................... 27
3.2 A Brief History of the Analysis of Risky Prospects ............................................ 30
3.3 Behavioural Theories of Decisions Facing Risk .................................................. 42
Chapter 4 - Empirical Research on Risky Preferences ...................................................... 54
4.1 Experimental Techniques ............................................................................................. 54
4.2 Experimental Methods for the Extraction of Preference ............................... 59
4.3 Experimental Evidence on Risk Preference ......................................................... 69
Chapter 5 - Methodology ................................................................................................................. 84
5.1 Methodological Approach ............................................................................................. 84
5.2 Introducing the Experiment ........................................................................................ 90
5.3 The Rankings Section ...................................................................................................... 93
5.4 Contingent Valuation.....................................................................................................101
5.5 Statistical Analysis ..........................................................................................................110
Chapter 6 - Key Findings on Revealed Preference ............................................................113
6.1 Evidence of High and Low Significance ................................................................113
6.2 Rankings ..............................................................................................................................117
6.3 Valuations through Willingness to Pay ................................................................120
6.4 Valuations through Willingness to Accept ..........................................................127
6.5 Comparative Analysis of Key Findings .................................................................128
6.6 Implications of Key Findings .....................................................................................138
Chapter 7 - Conclusion....................................................................................................................150
7.1 Future Studies in the Analysis of Risk Preference ..........................................152
7.2 Future Studies in the Analysis of Probability ....................................................153
7.3 Concluding Remarks......................................................................................................155
Appendix A - Beliefs .........................................................................................................................157
Appendix B - The Questionnaire ............................................................................................... 160
Appendix C – Statistical Analysis ...............................................................................................183
Abbreviations ......................................................................................................................................193
Bibliography ........................................................................................................................................194
iii
List of Tables
Table 1.1: Risk Appetite According to Prospect Theory ................................................. 5

Table 1.2: Drivers of Choice According to Risk Profile .................................................... 5
Table 3.1: St Petersburg Paradox Payouts.......................................................................... 33
Table 3.2: Allais’ Paradox ............................................................................................................ 39
Table 3.3: Loss Aversion Coefficients.................................................................................... 46
Table 4.1: Holt and Laury’s Low Payout Pairs .................................................................. 67
Table 4.2: WTA vs WTP Disparity Surveys......................................................................... 80
Table 5.1: The Lotteries of Bundle LB................................................................................... 96
Table 5.2: Summary of Lottery Bundles in the Rankings Section ........................... 97
Table 5.3: First Step in Sequential Equivalence Willingness to Pay .....................106
Table 5.4: Sequential Equivalence Lottery Bundle SLB .............................................107
Table 5.5: Statistical Tests per Section ...............................................................................114
Table 6.1: Changes in Significance of Amounts for Gains and Losses .................114
Table 6.2: Cumulative Significance.......................................................................................115
Table 6.3: Implied Ranges of Significance.........................................................................116
Table 6.4: Comprehensive Results on Lottery Bundles .............................................117
Table 6.5: The Statistical Significance of Differences in Risk Appetite .........Error!
Bookmark not defined.
Table 6.6: Mean and Median WTP ........................................................................................121
Table 6.7: WTP and SWTP Disparity ...................................................................................122
Table 6.8: Median WTP and SWTP Values per Lottery ..............................................124
Table 6.9: Number of Prices Given per Lottery ..............................................................125
Table 6.10: Summary of Contingent Valuation Means and Medians .......................128
Table 6.11: Standard Deviations of WTP, SWTP and WTA amounts ................... 1311
Table 6.12: Equiprobable Lotteries ..................................................................................... 1322
Table 6.13: Comparison of Group Ratio Means vs Individual Ratio Means ........133
Table 6.14: Prices per Round and Corresponding CEFsError! Bookmark not
defined.
Table 6.15: WTA and SWTA CEFs ................................Error! Bookmark not defined.
Table 6.16: Factor Interaction of Loss-Adjusted Risk Aversion (LARA)...............137
Table 6.17: Loss Aversion Implied in CEFs .........................................................................135
Table 6.18: The Significance of Payouts and Perceived Risk .......................................148
Table A-1: Overview of Observed Biases and Heuristics............................................148
Table B-1: Overview of Questionnaire and Layout .......................................................148
Table C-1: Subjective Significance of Gains and Losses ..............................................184
Table C-2: Rankings of LBs .......................................................................................................185
Table C-3: Fisher’s Exact Test Results for Recoded Rank Orderings ...................186
Table C-4: Wilcoxon’s Test Results for Impact of EV on Risk Appetite ...............188
Table C-5: Willingness to Pay Amounts: Win-Only Section ......................................188
Table C-6: Wilcoxon’s Test Results for WTP Value Changes ....................................189
iv
Table C-7: Sequential WTP (SWTP)......................................................................................189
Table C-8: Wilcoxon’s Test Results for WTP Value Changes ....................................190
Table C-9: Willingness to Accept Prices .............................................................................190
Table C-10: Wilcoxon’s Test Results for WTA Value Changes .....................................191
Table C-11: Wilcoxon’s Test Results for SWTP-WTP .......................................................191
Table C-12: Wilcoxon’s Test Results for WTA-WTP .........................................................191
Table C-13: Wilcoxon’s Test Results for WTA-SWTP.......................................................192
Table C-14: Wilcoxon’s Test Results for SWTP/WTP ......................................................192
Table C-15: Wilcoxon’s Test Results for WTA/WTP ........................................................192
Table C-16: Wilcoxon’s Test Results for WTA/SWTP ......................................................192
Table C-17: Wilcoxon’s Test Results for WTA vs C+|Max Loss| ..................................193
List of Figures
Figure 1.1: The Assessment of Risky Prospects ................................................................... 3

Figure 1.2: Contribution of Payouts and Probabilities to Binary Lottery Risk ..... 6
Figure 2.1: Uncertainty in Ambiguity and Risk ................................................................. 19
Figure 2.2: Utility as a Function of Wealth .......................................................................... 24
Figure 2.3: A Representation of the Certainty Equivalent ........................................... 26
Figure 3.1: Prescriptive Theories of Economic Behaviour under Uncertainty .. 27
Figure 3.2: A PT Value Function .............................................................................................444
Figure 3.3: Α PT Weighting Function ..................................................................................... 47
Figure 4.1: CE elicitation methods........................................................................................... 60
Figure 6.1: Cumulative Revealed Risk Appetite ..............................................................117
Figure 6.2: Rankings per Risk Level......................................................................................119
Figure 6.3: Revealed Risk Appetite in Low Payout and High Payout Bundles .119
Figure 6.4: Disparity of WTP vs SWTP ................................................................................124
Figure 6.5: Mean [SWTP/WTP] vs [Mean SWTP/Mean WTP].................................124
Figure 6.6: WTA, WTP and SWTP prices ............................................................................129
Figure 6.7: Means and Medians for [WTA/WTP] and [WTA/SWTP] ratios ... 1300
Figure 6.8: An Asymmetric Significance of Amounts ................................................ 1400
Figure 6.9: WTA and WTP Approximation of the CE ................................................. 1303
v
Acknowledgements
Working on this Ph.D. has been an overwhelming, humbling and challenging

experience. I complete this journey with a profound sense of fulfilment, but also
with feelings of sincere gratitude for the people who have, in one way or another,
paved my way to academic contribution.
Firstly, I would like to thank my supervisor, Dr. Yannis Bassiakos. His generous
contribution of personal time and effort was critical, and his valuable input made
all the difference in the completion of this thesis. I am deeply grateful.
I would also like to thank my supervisors Dr. Panagiotis Alexakis and Dr.
Dimitrios Moschos, for their encouragement and participation in my research.
My grateful thanks are also extended to Dr. Panagiotis Andrikopoulos for his
valuable and constructive suggestions. The input of a truly knowledgeable
academic in the field of behavioural finance is greatly appreciated.
I am also grateful to Dr. Yanis Varoufakis, his academic direction and vision was
an inspiration in my early years in research.
Finally, I would like to thank my parents, Panos & Agni Mita, my husband,
Alexandre Moulin and my children, Nathalie and Philippe, for their unconditional
love and support. I did not give up because of them, so this is no more my
achievement than it is theirs.
Katerina Moulin – Mita
vi
Chapter 1 - Introduction
Human behaviour is a fascinating field of study for a wide variety of sciences

ranging from biology to psychology and from sociology to economics. For
economics and finance, the behaviour of economic agents plays a leading role in
most schools of thought. A key element of economic behaviour is decision
making, including the procedures and processes that lead to preference and
choice.
All decisions share a common characteristic: they materialize in the future, as

there is no point in making decisions about things in the past. The moment a
decision is taken it refers to some point in time ranging from right now to several
years from now. As a result, all decisions incorporate some amount of risk. With
financial decisions the presence of risk is more dramatic and indeed in some
cases dominates the decision problem. In theory, risk and returns are positively
related, in the sense that increased returns accompany increased risk. To
illustrate, consider a relatively “safe” investment: a standard deposit bank
account with a fixed annual interest rate. The deposit reflects the default risk of
the bank and the risk of opportunity cost related to an increase in interest rates.
A top tier UK bank in 2012 paid a fixed 0.5% annual interest rate for a €10,000
deposit. A standard Greek bank would pay 3.5% p.a. for the same deposit
account. Interest pays more for various reasons, many of which are related to the
fact that Greek banks are subject to a higher default risk. This type of risk-return
relationship extends throughout the entire spectrum of investment products,
and indeed across several aspects of everyday life. The decision to deposit one’s
savings in a UK bank versus a Greek bank essentially trades a higher interest for
a lower default risk. This decision is an indirect statement of risk aversion,
revealed through preference. This thesis analyses such statements of preference
and introduces a new perspective towards the efficient non-parametric
estimation of risk appetite.
1
Chapter 1 Introduction
According to Bernstein (1996), “human beings have always been infatuated with
gambling because it puts us head-to-head against our fates”. A glimpse of nature
is filled with examples of games of luck with survival at stake. It therefore comes
as no surprise that games of luck have been a human practice since the beginning
of recorded time. Astragals, a primitive form of dice used for gambling around
3,500BC was found in an Egyptian tomb. Evidence of voluntary risk taking can be
found throughout the animal kingdom; evidence of unnecessary risk taking,
however, is scarce, pointing to the assumption that we live in a world of risk-
aversion. In fact, despite the uncertainty regarding the future state of the world,
a common assumption taken for granted is our status quo and it is precisely the
status quo that drives a risk aversion for some decision makers. For others, risk
taking is a disposition.
The interdisciplinary nature of financial decision making facing risk borders

between behavioural and economic sciences. Though extensively researched,
theory remains largely inconclusive, with substantial prescriptive and
descriptive shortcomings. The theoretical analysis of the assessment of risky
prospects is based on two benchmark theoretical frameworks. Firstly, the
normative approach of the various Expected Utility theoretical frameworks
incorporates the subjective transformation of the risky values into utilities and
the hierarchy of prospects for decision makers departs from objective valuations
according to the resulting risk appetite and subjective utility. Secondly, the
descriptive approach of reference dependent theories, such as Prospect Theory,
incorporates the subjective transformation of both value and probability to
analyse the hierarchy of preferences among risky prospects. For the behavioural
finance school, the importance attached to payouts and probabilities has been
the subject of extensive analysis, in various contexts.
Building on the existing literature, it is evident that choice and revealed

preference between risky prospects entails a three-dimensional preference
ordering that includes a) the ordering of the payouts, b) the ordering of the
probabilities attached to them, and c) the ordering of the prospects, i.e. the
probability-payout pairs. Surprisingly, while the analysis of a) and b) have
2
independently become the subject of prolific analysis and insightful research,

their interaction remains largely under-researched.
Figure 1.1 below summarizes the objective and subjective assessment processes
that interact towards the construction of preference and which forms the key
subject of this thesis. Based on objective valuations, the ranking of risky
prospects is fairly straightforward. High probability to win the high payout is
preferred to high probability to win the low payout, and the value of any
prospect with known probabilities and payouts is objectively defined as the
expected value of the prospect.
Figure 1.1: The Assessment of Risky Prospects
Objective Perspective Compared to each

other
High Payout Low Payout
Compared to reference point
Wealth
Assessment of Payouts
Prospect
Assessment
Assessment of Probabilities
Personality Traits
Filtered by disposition
High Probability Low Probability

Compared to each
Objective Perspective other
The assessment of prospective payouts is assumed to be a function of final

wealth in expected utility theory and a point of reference for departures from
status quo in reference-dependent theories. In this thesis, a subjective ordering
3
of payouts in terms of their subjective significance is introduced. Moreover, the

assessment of payouts and of probabilities is assumed to be independent of each
other. In this thesis, this assumption is challenged.
A common illustration that simplifies the analysis of a risky financial prospect is

a lottery. Consider a simple game with 3 equally probable outcomes: a prize of
€1,000, a prize of €0 and a loss of -€150. A decision maker faced with the
decision of whether or not to play the game essentially evaluates the prospect
according to three equi-probable payouts. The probabilities are explicitly
determined and set at 33.33% for each outcome. The assessment of this prospect
differs according to each decision maker’s attitude to risk. In value terms, the
expected value of this prospect is €283 > 0, so a risk neutral decision maker
would certainly be willing to play the game. However, if we present this prospect
to 100 people, some of them might refuse to participate. The reason why they
would refuse lies with the potential loss of €150 which, however small, might
exceed the amount the decision maker is willing to risk losing. On the other hand,
as discussed in this analysis, the reason may well be that the potential loss of
€150 bears more “significance” for the particular decision maker than the
potential gain of €1,000.
Indeed in financial decision making the impact of subjectivity is fundamental.

Markets move because different economic agents, with different needs,
preferences and expectations, interact and exchange in order to satisfy their
wants and needs, revealing their preferences, based on their expectations. While
academic research has gained significant insight in terms of theory using
parametric approximations and axiomatic theoretical frameworks, with
normative and descriptive theories coexisting, the non-parametric analysis of
preference construction when dealing with financial prospects remains
relatively unexplored. For instance, violations of Expected Utility documented
under a variety of descriptive, real-life conditions often lead to the dismissal of
EU principles as a whole, or to a wide range of descriptive theories that exclude
or relax one or more of these principles. There is, as of yet, no conclusive theory
that can substitute EU in its entirety, or that can offer an “all-weather”
alternative to the normative extensions of EU. This may well be an indication
4
that a non-parametric analysis of the components of financial decisions is

required, and this study of preferences among financial prospects is a step in that
direction.
The impact of the subjective significance of payouts on decisions under risk

shall be the first point to be investigated in this research thesis. Table 1.1 below
presents an analysis of risk appetite according to Kahneman and Tversky (1979)
in their introduction of Prospect Theory. The descriptive patterns described
reflect an asymmetric attitude towards gains and losses, contingent upon the
probability distribution.
Table 1.1: Risk Appetite According to Prospect Theory
Outcome Probability Risk Seeking Risk Averse

Low X
Gains Moderate X
High X
Low X
Losses Moderate X
High X
Source: Kahneman and Tversky (1979)
Schoemaker (1989) extends the asymmetric handling of gains and losses and
argues that risk appetite and payouts determine which lottery component is
most important in the decision making process. His assumptions are presented
in the table below. The underlining argument of Schoemaker (1989), as in
Kahneman and Tversky (1979) above, is that the definitive component of any
decision problem varies, as does risk appetite. For instance, a conservative
decision maker faced with a set of gain opportunities shall choose the prospect
offering the highest probability of winning. A risk-seeker faced with the same
prospects will prefer the prospect with the highest payout.
Table 1.2: Drivers of Choice According to Risk Profile
Risk Appetite Gain Problems Loss Problems

Risk-Averse Probabilities Payouts
Risk-Neutral Indifferent Indifferent
Risk-Seeker Payouts Probabilities
Source: Schoemaker (1989)
5
Similar assumptions were made by Slovic and Lichtenstein (1983; 2006) with
the grouping of prospects into p-bets and $-bets, the former featuring high
probability for low payout and the latter featuring low probability for a high
payout.
As implied by behavioural finance theorists, there is an interaction of payouts

and probabilities in risky choice. A hypothetical relationship between payouts
and probabilities is presented in Figure 1.2 below, where the risk classification of
any prospect is the result of the interaction between the level of the payouts and
their corresponding probabilities of occurrence.
Figure 1.2: Contribution of Payouts and Probabilities to Binary Lottery Risk
Payout
Positive Mixed Negative

High/Low Gains Positive and High/Low Losses
Negative
Risky Less Risk Moderate Risk High Risk

Prospect Opportunity Cost Potential Losses or Certain Cash Outflow
Opportunity Cost
High for Desirable Low for Desirable

Payout Moderate Payout
Probability
The general assumption in this representation is that the lower the probability
for the desirable outcome, the riskier the prospect. This assumption applies to
mixed, loss-only and gain-only lotteries alike, and although it is a fairly
straightforward relationship, it becomes more complicated with the introduction
of subjectivity. After all, both the payouts and the probabilities are being
assessed by human beings under the subjective prism of individual perception.
6
While as indicated in the tables and the figure above the asymmetric perception
of gains versus losses is acknowledged, the impact of the magnitude of gains and
losses in decisions under risk is rather under-emphasized. Throughout this
analysis the magnitude of the payouts and the subjective significance they bear
for the decision maker is examined, with particular emphasis on whether the
subjective significance of payout amounts can cause a shift in revealed
preference, implying a change in risk appetite.
This thesis will also focus on the development of a new methodology for the
extraction of the certainty equivalent. When examining decisions facing risk,
preference analysis usually skims the uncertainty out of the risky prospect by
extracting its certainty equivalent. Certainty Equivalents1 (CEs) are certain
amounts (i.e. featuring a 100% probability of occurrence) of equal significance,
attractiveness or desirability for each decision maker as the risky prospect. They
imply the ordering of preferences and contain important information on the
decision makers’ appetite for risk.
Given the importance of the accurate extraction of certainty equivalents, it is

surprising that there is still substantial vagueness regarding the procedures for
the extraction of the certainty equivalent of risky prospects, as well as the
accuracy and reliability of the amount itself. Relevant literature incorporates
substantial ambiguity in terms of a) experimental techniques, such as empirical
procedures, sample selection, setup of choice problems, etc., b) data analysis,
such as the comparison of group vs individual data, simplification assumptions
on data ranges, etc. and c) theoretical extensions, for example assumptions of
utility functions and risk aversion. To address these issues, in this study I shall
examine existing elicitation procedures for the Certainty Equivalent. I introduce
an innovative technique called Sequential Equivalence which effectively converts
the paid purchase of a win-only lottery into a mixed lottery. The method leads to
an insightful analysis of the perception of risk in win-only and mixed lotteries
and sheds light on the existence and extent of the endowment effect. This
1 A definition of the Certainty Equivalent is provided in the section that follows and is extended
throughout this analysis.
7
methodology essentially traces framing effects and reverses their impact to

construct sequential equivalents.
I present rankings and contingent valuation results from the same individuals,
drawn through a computer-based questionnaire comprising up to 78 lotteries.
The questionnaires were completed in personal meetings with each of the 52
subjects. The tasks included rankings and contingent valuation, producing
directly comparable data across subjects.
Subjects are professional or skilled individual investors, with investment

experience and a grasp of probability and the risk-return tradeoff relationship. In
most research on risky prospect preference and choice, subjects are (young,
inexperienced) students with limited or no professional experience and a rather
uniform perception of the mathematical aspects of the prospects presented.
Finally, prospects involve real payouts of significant levels, and that significance
is validated for each subject to ensure relevant uniformity in terms of wealth
effects. With the exception of a handful of researchers who drew their samples
from low-income communities in order to afford real payouts of significant
amounts in their experiments, most empirical evidence on preference among
risky prospects pertains to prospects with payouts equal to very insignificant
amounts by Western economies’ standards, such as $1 or $2. Both in terms of
risk appetite and tolerance, and in terms of cognitive effort, the validity of the
data may be compromised and the incentive of a real payout is undermined
when subjects are largely indifferent towards the potential payouts.
A final consideration is the theoretical framework within which risky

preferences are analysed. The prevailing theory with aspirations for
descriptive accuracy is Prospect Theory. Having extracted certainty equivalents
and risk appetite, the estimated measures of risk aversion and loss aversion
provide further insight on the subjective perception of risk and any loss aversion.
This application of theory to revealed preference2 data often leads to the non-
parametric approximation of risk appetite. To that effect, in this thesis the
2Revealed preference is the term used to describe preferences that are implied by choice, i.e. not
explicitly stated, but inferred from the characteristics of the items chosen.
8
efficient extraction of certainty equivalents shall form the basis for the
construction of an estimator of loss-adjusted risk aversion (a measure
introduced here as “LARA”).
The subjective assessment of risky prospects, on which the construction of

preference is based and from which choice is driven, is influenced by a number
of factors, including heuristics and biases that cause substantial deviations from
normative theory predictions. Empirical evidence on preferences over risky
prospects highlights a number of violations of the predicted patterns of rational
choice theory. Many of these violations lead to preference inconsistency. One
such example is choice-implied preference reversal whereby subjects state a
preference for one prospect over another, and then state a higher purchase or
selling price for the least preferred prospect. Another example is the striking
disparity between bid and ask prices for the same prospect. This disparity,
known as the endowment effect, is the observation that subjects considering the
purchase of a prospect tend to state a maximum price that is lower than the same
subjects’ minimum selling price. A final example is risk aversion and the
observation that attitudes towards risk are asymmetric around a reference point.
There is no consensus regarding the definition of that reference point or on the
nature of the asymmetry, but reference dependence is empirically documented
as a series of inconsistencies in preferences that disappear when a reference
point perspective is introduced in the analysis.
In response to the above theoretical arguments widely available in prior

literature, this research study explores financial decisions facing risk with
emphasis on descriptive, rather than prescriptive, accuracy. Chapter 2
introduces and defines the key concepts analysed in this thesis and in Chapter 3
I present a brief history of risk in preference theory from the emergence of
probability until the neoclassical school expected utility hypothesis and the
prevailing modern behavioural finance theories of reference dependence. Within
the context of reference dependence, the asymmetric significance of amounts can
be supported and incorporated in theory.
9
In fact, it is precisely the descriptive failure of normative theory that points to

the reference dependence of preferences in financial choice. Some of the more
striking violations of traditional economic theories of choice are presented in
Chapter 4 where some of the most influential papers on the subject of revealed
preference are discussed and a critical review of relevant research and findings
is presented.
The methodological shortcomings, including those related to experimental

technique, are discussed further in Chapter 5, where I present my methodology.
This analysis extracts primary data from a controlled experiment, specifically
designed to reveal preferences among various risky prospects. Firstly, the study
examines if revealed preference among uncertain monetary payouts, such as
investment prospects, is contingent upon the subjective significance of the
amounts involved. For instance, it tests if as the subjective significance of the
payouts increases, risk aversion increases.
Secondly, acknowledging the asymmetric assessment of gains and losses (“loss

aversion”), the asymmetric significance of amounts extends to show that
equivalence exists around the point at which gains and losses bear equivalent
significance, i.e. the limiting common value where WTP and WTA approach the
CE. At that point, the impact of any endowment effect is minimized.
Thirdly, this study further confirms the framing and context effects and applies
their impact to extract a better approximation of certainty equivalents. Through
the introduction of an innovative method I call “Sequential Equivalence”, loss
aversion is extracted and isolated, indicating that any endowment effects can be
substantially reduced. In terms of contribution to experimental economics, the
contribution of this analysis is twofold: In terms of experimental methodology, it
introduces an improved methodology for Contingent Valuation. In terms of
empirical findings, it produces valid primary data on professional investor
preferences among risky prospects.
The findings of the experimental approach described above are presented and
analysed in Chapter 6. This thesis confirms that risk aversion decreases as
payout amounts increase. Moreover, the difference between WTP and WTA is
10
confirmed but a critical underestimation of the amount decision makers are

willing to risk is recorded. As sequential equivalence reveals, traditional
contingent valuation methodologies may lead to an inflated WTA/WTP disparity
through an understated WTP (and, perhaps, an overstated WTA). The proposed
methodology converts no-loss lotteries into mixed lotteries, producing a natural
test for loss aversion. In fact, when the SE method produces a better
approximation of the certainty equivalent, a good estimation of the behavioural
assumption of loss aversion is possible.
The asymmetric significance of amounts and the principle of loss aversion are
both evidence of reference dependence. The impact of this indication is twofold.
Firstly, it leads to a non-parametric valuation of risk aversion that does not
require the assumption of a utility functional form. Secondly, it results in a self-
contained measure of risk appetite introduced in this research as “Loss-Adjusted
Risk Aversion” (LARA).
This thesis concludes in Chapter 7 with a summary of the key findings. Emphasis
is given on extensions of this research and indications on the direction of future
studies to complement, enhance and expand the views presented herein.
11
Chapter 2 - Key Concepts in Financial Decision Making
The perspective through which financial decisions facing risk are approached in
this study is introduced in the following sections.
2.1 Some Definitions
2.1.1 Financial Decisions
Seldom in life are decision makers faced with certainty regarding things to come.
Indeed every day economic agents make decisions between alternative
consumer3 or financial products, unaware of what the future state of the world
will be. In the case of consumer products, the decision making process may be
based on personal tastes, sociocultural factors, the political environment, a
variety of explicitly and/or implicitly determined variables, including predictions
and expectations.
In finance, however, where decisions are primarily about money, much of the
complexity of consumer theory is diverted: Irrespective of personal tastes and
preferences, people will prefer more money to less money. Although personality,
disposition, religion, political views or sociocultural characteristics might alter
the intensity with which individuals desire money, one might safely assume that
in most societies the only commodity that is more desired than cash is more cash.
Decisions regarding an investment, on the other hand, start off with an obvious
assumption: They are made by economic agents who want to safeguard or
increase their net worth. With the desire to earn more money as opposed to less
money or to lose less money as opposed to more money, decisions regarding
financial products heavily depend on risk appetite, which incorporates, among
other uncertainties, an estimation of the future state of the world.
3 Consumer products incorporate consumer durables, consumer non-durables and soft goods. A
financial product is defined as a means through which economic agents make financial
investments, manage financial risks or make non-cash payments.
12
Chapter 2 Key Concepts in Financial Decision Making
Financial decision making includes a wide variety of decisions, in both the micro
level – such as corporate finance decisions, and the macro level – such as
decisions regarding the monetary policy of a sovereign state. Throughout this
thesis, insight accumulates on financial decisions of individual decision makers
managing sections of their wealth through the acceptance or rejection of
investment decisions with monetary outcomes. The broad definition4 of an
investment decision is “the decision of where, when, how and how much capital
to spend and/or debt to acquire in the pursuit of making a profit”.
With investment products, two assumptions are traditionally made: a) Investors

prefer gains to losses, and b) investors seek to maximize their gains. Examples of
investment prospects include the investment in shares of a company, whereby
investors expect to obtain dividends and/or realize capital gains. When
evaluating the investment prospects of a stock, uncertainty affects nearly all of
the parameters: Investors are unsure about the probabilities attached to the
level of dividends (if any), as well as the probabilities of potential price changes
in the share price. As a result, their investment decision is based largely on their
beliefs5 about future corporate performance, the performance of the local and
global markets, in other words they are influenced by their assessment of
systemic and systematic risk.
How much to invest, when to stop loss, when to take profit, which investment to
choose and when, which financial product to buy and hold, whether or not to
partially or fully hedge an investment position, etc. are all financial decisions that
can be presented as lottery-type decision problems, with known or unknown
probabilities and/or payouts. In fact, the decision to participate in a lottery may
contain less uncertainty than the decision to invest in the stock market, for the
simple reason that the lottery has predetermined chances of winning and/or
losing various amounts. Prospects involving uncertain outcomes are often
represented in lottery form and indeed research has confirmed the correlation
between gambling preferences and investment decisions (Kumar, 2009).
Lottery-type decision problems can be mixed, i.e. offering both gains and losses,
4According to financial dictionaries; this definition in the Farlex Financial Dictionary, 2012.
5The formulation of beliefs lies beyond the scope of this research and probability distributions
are assumed to be known in the context of risky prospects considered throughout our analysis.
13
gain-only payouts and loss-only payouts. Investment decisions have very similar
profiles.
It is common for researchers to reduce risky choice to choice among lotteries or

bundles of lotteries6, and indeed researchers often analyse investment prospects
using lottery analogies. According to Barberis and Huang (2008), for example,
stocks can be analysed as lotteries and the implications of probability weighting
for security prices indicate the similarities of investing with “raw” risk taking.
The intuitive response to the term “lottery” is that it is a gambling game. At first
glance, analyzing financial investments through lotteries seems “unsuitable”.
After all, investment decisions require knowledge and skill, while lotteries are
games of luck. Upon a closer look, however, a lottery is a finite and known
probability distribution over a set of finite and known monetary outcomes.
Investments, on the other hand, are prospects with unknown, subjectively
defined probabilities attached to an often infinite set of outcomes. Investments
normally contain the element of uncertainty, in fact it is precisely this
uncertainty that keeps the markets moving through conflicting expectations:
Buyers assume a higher probability to a rise in the share price, sellers assume a
higher probability that the stock will fall. The probabilities investors attach to the
future stock performance in the real world are largely subjective, determined
under conditions of ambiguity7, adding complication to the analysis of the
investment decision. The substitution of the assumed probability distribution
with a known probability for each outcome, essentially simplifies the decision
problem. The impact of this simplification and the real life investment equivalent
of some of the lotteries in our questionnaire are exemplified in real-life terms in
various contexts. For instance, what would a decision maker pay to participate in
the following prospect:
6 In traditional preference theory terminology a set of lotteries is called a budget, but in this
analysis the term bundle is preferred to avoid any financial connotation misunderstandings with
the term budget, which might be taken to mean a constraint on income.
7 Ambiguity conditions as opposed to conditions of risk. The distinction between ambiguity and
risk is defined in section 2.4 later on.
14
This risky prospect is essentially equivalent to a synthetic option investment to

which the investor attaches a 15% probability of capital gains of €10,000.
Moreover, consider the amount the decision maker requires in order to sell a
participation in the following prospect:
This risky prospect is essentially equivalent to an exit strategy of an investor

who holds an option for which he paid a premium of €500.
Finally, consider the following Lottery Bundle (LB), which comprises six lotteries
with the same expected value set at €1,500:
This set of prospects can be likened to the intrinsic value of alternative short
options positions, ranging from a deep in the money option (90% probability of a
€1,650 profit) to a deep out of the money option (15% probability of a €10,000
profit).
2.2.2 Preference
In this analysis, a preference for A vs B means the condition that states that when
faced with a choice the decision maker would choose A over B. Similarly, strict
preference is the condition that states that A is better than B, and B is not better
than A, noted . Weak preference is the condition that A is better or equal to
B, and B is not better or equal to A, noted Indifference is the condition
that A is as good as B, henceforth denoted .
Preference ordering can be measured on ordinal and cardinal scales. Ordinal

scales measure the ranking of the preferences and not the magnitude of the
differences in preferences. Cardinal scales measure the numeric difference or
15
ratio between A and B, the former being the interval and the latter being the
ratio scale. Finally, when prospect A strictly dominates prospect B, then prospect
A is strictly better than B under all circumstances. Also, when prospect A weakly
dominates prospect B, the prospect A is as good as B under all circumstances.
A strong or weak preference relation ( respectively) reveals the ranking

of the prospects available to the decision maker. Assuming a vector of available
outcomes comprising prospects , across which the decision
maker has well-specified preferences, rational choice predicts that the decision
maker picks the prospect bundle so that no other is strictly better than .
Similarly, one can infer that when a decision maker chooses over any other
in , then the decision maker considers to be strictly better than any other
in . This preference ordering can be presented in the context of a utility
function, according to a set of axioms that must be satisfied for any utility
function to represent well-defined preferences.
As a final note, preferences may be habitual or intuitive, in which case the choice
decision is mechanical and occurs with relevant consistency time after time. On
the other hand, preferences may be constructed, for example the choice problem
is new and unfamiliar. Preference construction is considered by many as one of
the leading reasons for preference reversals (Slovic and Lichtenstein, 2006).
Preference ordering often reflects the shape of utility functions and revealed
preferences may well be the only access researchers have to utility quantification
as utility cannot be directly stated or observed. The task, however, often involves
a great deal of improvisation. In experimental settings preferences are revealed
under controlled conditions for the filtering of biases and the isolation of specific
effects. The prevailing methods of revealing preferences are Ranking and
Contingent Valuation (CV) tasks.
Ranking refers to the method of ordering alternative goods and/or services, or

bundles thereof, in terms of attractiveness, leading to the extraction of ordinal
utility. To illustrate, consider the lotteries in LB mentioned previously. Assuming
a decision maker ranks these six lotteries by order of attractiveness, stating that
the last lottery is his top choice and the first lottery his last choice. This ordering
16
reveals a preference for less risk. One of the issues addressed later on is the
consistency of such preference as payout levels change. For instance, suppose all
payouts are divided by 100. Would the decision maker’s preferences remain the
same?
On the other hand, CV comprises valuation tasks and extracts the prices assigned
to various prospects. Bid prices or Willingness to Pay (WTP) refer to the
maximum price decision makers are willing to pay for a prospect, be it riskless,
such as a good or a service, risky such as a lottery, or uncertain, such as shares of
a company. The method allows for the extraction of ordinal and cardinal utility,
on the presumption that the higher the price someone is willing to pay, the
higher the desire to acquire the prospect. Revealed preference in this case stems
from the fact that higher priced prospects are more desirable than lower priced
prospects. Along the same lines, the ask price or Willingness to Accept (WTA)
essentially inverts the question to extract the selling prices for a prospect.
Although both pricing tasks are similar and should result in similar prices,
substantial differences have been reported. This observation is commonly
considered to be an indication of loss aversion, referred to as the “endowment
effect”.
As a final note on the definition of WTP, in prior literature WTP refers to the
revelation of a bid price, the maximum price the subject is willing to pay to
purchase a good, a service or a risky prospect. When the underlying prospect
involves strictly monetary payouts, WTP is sometimes defined as the sure loss
someone is willing to take in order to avoid the potential of incurring a larger
loss through the risky prospect. The term WTP throughout this research is used
as in Willig (1976) to mean the maximum amount the decision maker is willing
to pay to purchase a lottery ticket.
2.2.3 Utility
Utility is the satisfaction derived from the consumption of a good or service.

While the value of a good or service may be an objectively, explicitly determined
amount to be taken as a given, utility has subjective dimensions that depend on
17
personal preferences inherent to each individual. In practical terms utility8 is the

representation of individual preference over some set of prospects, and in
theoretical terms it is the axiomatic transformation of preferences into
comparable units. Among the benefits of this comparability is the construction of
indifference curves incorporating trade-offs between alternative prospects
incorporating the ordering of preferences.
A very particular utility pertains to a commodity that, in theory, people

constantly need more of; money. The utility of money has the following
properties:
a. Concavity – Diminishing marginal utility is derived from positive monetary

payouts
b. Boundedness – Money has finite utility which disappears beyond a certain
point
c. Asymmetry – The utility of gains is not equal to the disutility of losses, as the
perception of the magnitude and impact of gains is different from losses
Criticism on the use of utility as a way to rank, compare or understand

preferences has been voiced by many researchers. Indicatively, Robinson (1962)
speaks of a cyclical pattern in utility analysis and argues that “utility is the
quality in commodities that makes individuals want to buy them, and the fact
that individuals want to buy commodities shows that they have utility”.
2.2.4 Risk versus Uncertainty
In every day discussion the terms risk and uncertainty are often used
interchangeably. Economic theory, however, often distinguishes between
situations where mathematical probabilities are explicitly determined and
known, as well as situations where mathematical probabilities are unknown,
variable or assumed. Keynes exemplifies uncertainty in The General Theory of
Employment (1937, page 113 ):
8 Often referred to as “total utility”, for example in consumption economics
18
“The sense in which I am using the term is that in which the

prospect of a European war is uncertain, or the price of copper and
the rate of interest twenty years hence” ,
and distinguishes between uncertainty and risk, stating that in the face of
uncertainty “there is no scientific basis on which to form any calculable probability
whatever”.
This distinction between uncertainty and risk dates back to Knight (1921) who
defines uncertainty as the condition where the probability distribution and/or
the set of outcomes are unknown, subjectively determined or questionable. The
term risk is used where the probability distribution and the set of outcomes is
known – Keynes (1937) refers to the game of roulette to exemplify risk.
Abiding by the distinction between known and unknown probabilities and

payouts, in this thesis the terms uncertainty and risk are used interchangeably to
characterize decision problems involving reductions in certainty, much like in
other research (for example Quiggin, 1993). The kind of uncertainty where
probabilities or payouts or both are unknown is herein referred to as ambiguity
or ignorance (as in Peterson, 2009). This relationship between known and
unknown components of an uncertain prospect is presented in the figure below.
Figure 2.1: Uncertainty in Ambiguity and Risk
Uncertainty
Probabilities
Unknown Known
Payouts
Ambiguity Risk
‘Uncertainty’ in this research pertains to any ‘reduction of certainty’ and

uncertainty is assumed to be the prevailing characteristic of risky prospects with
known, explicitly stated probabilities. Decision problems in conditions of
ambiguity lie beyond the scope of this research. By excluding ambiguity, this
19
analysis focuses exclusively on problems with a “measurable” level of

uncertainty where probabilities and outcomes are objectively defined. A
substantial amount of complexity is thereby removed from this analysis, as
discussed later on. The sort of uncertainty in decisions among risky prospects
can be presented as a lottery-type decision problem, and throughout this
analysis I shall refer to the selection and pricing of binary lotteries as described
in section below.
2.2 Lotteries as Risky Prospects
Introducing lotteries and their notation, in this analysis a lottery is defined as

follows:
(1)
offering a monetary value set of exhaustive, mutually exclusive consequences:
(2)
contingent upon the following probabilities:
(3)
where ∑
Mixed lotteries are lotteries with outcomes both gains (positive payouts) and
losses (negative payouts). Risk pertaining to any reduction of certainty in mixed
lotteries is fairly straightforward, it refers to the lose scenario of coming up with
the negative payout.
For profits-only lotteries, i.e. lotteries offering various levels of gains, risk
pertains to the opportunity costs incurred if the lowest outcome is paid. This
approach is widely used in prior literature, for instance in Binswanger (1980;
1981) who considers a win/win lottery risky simply due to the opportunity cost
of the high payout. As Thaler (1980) notes, opportunity costs should be treated
as out-of-pocket costs, so the treatment of a mixed lottery is not dramatically
different from a gains-only lottery.
20
The objective “riskiness” of a lottery can be readily assumed to be a given,

through the calculation of Expected Value (EV). In its primitive form the value a
decision maker assigns to a prospect is a simple calculation of the sum of the
probability and value pairs of the prospect, as follows.
̃ ∑ (4)
The assumption that EV maximization will drive choice facing risky prospects
gives rise to numerous descriptive pitfalls, primarily due to the uniform handling
of all risk levels and payouts in the calculation. To illustrate this, let’s consider
the following two lotteries:
and
Both lotteries have the same EV:
̃ ̃
However, very few individuals would be indifferent between the two lotteries, as
some of us would be uncomfortable accepting the 50% chance of losing €50,000
that is implied in The inherent risk of , in other words, outweighs the
appeal of the maximum payout of €100,000. As a result, most risk averse
individuals would state a strong preference for , a preference relation that EV
cannot incorporate.
The differentiating point in preferences lies with the transformation of objective

values into subjective utilities, i.e. the evaluation of instead of ̃ as follows:
∑ (5)
According to Expected Utility Theory9 (EUT), in order to define as in the

equation above, preferences must have the following properties:
9 Henceforth Expected Utility, Expected Utility Theory and Expected Utility Hypothesis referred
to as EU, EUT and EUH respectively, often used interchangeably to mean Expected Utility.
21
a. Completeness: Any two lotteries can be ranked by preference and either

or
b. Transitivity: If and , then .
c. Continuity: there is a probability for which the decision maker is
indifferent between and .
d. Monotonicity: that assigns a higher probability to a preferred outcome shall
be preferred over a lottery which assigns a lower probability to the preferred
outcome, ceteris paribus.
e. Independence: Indifference (or preference) between two possible outcomes
implies indifference (or preference) between two lotteries with equal
probabilities to these outcomes, ceteris paribus. For example, assuming
payouts , and , if is preferred to , then an even chance to gain or
is preferred to an even chance to gain or . This assumption, also
known as the substitution or cancellation assumption in EUT is essentially
equivalent to the extended sure-thing principle (Savage, 1954) and the
independence condition (Krantz et al., 1971) and implies linearity in
probability as in the calculation of EV.
Adding current wealth W into (5) leads to a utility representation as a function of

final wealth:
(6)
For the risk that bears is the risk of not winning the higher of the
two outcomes, , and that risk is an opportunity cost equal to .
However, as is the least possible gain the decision maker expects from this
lottery, any such prospect de facto results in at least . For , the
risk of not winning is the source of uncertainty. For lotteries that include both
positive and negative outcomes the risk of losing corresponds to a cash
outflow. The opportunity cost of not gaining the high payout is in this case
secondary to the risk of negative payouts, unless of course the level of these
negative payouts is very insignificant to the decision maker.
22
2.3 Risk Aversion
When faced with monetary risky prospects, risk appetite is reflected in the
amount of money the decision maker is willing to sacrifice for a chance to gain
the desired outcome. Any lottery is a fair gamble if the expected value of ,
̃ and in the absence of a positive or negative disposition for risk, i.e. risk
neutrality, decision makers are indifferent between playing and not playing . A
weakly risk averse decision maker would be indifferent or negative to accepting
any fair gamble. Weak risk aversion therefore exhibits the following preference
ordering:
̃ (7)
Strict risk aversion, i.e. the rejection of a fair gamble, is ̃ . The definitions of
risk neutrality and risk seeking are analogous. By Jensen’s inequality:
(8)
and ( ) (9)
where is the utility assigned to the expected value of the lottery, and
is the expected utility of the lottery.
The principle of risk aversion assumes the concavity of the utility function
which incorporates the decreasing marginal utility of money and, assuming
is concave, continuous and differentiable, , i.e. changes in utility for L, is
non-increasing, at a decreasing rate whereby . In the graphical
representation below, the impact of risk aversion on utility is exemplified.
is the expected value of wealth W, is the risk averse utility of ,
is the risk seeking utility of , and is the utility of wealth
under the assumption of risk neutrality.
23
Figure 2.2: Utility as a Function of Wealth
Utility
Risk Aversion
Risk Neutrality
Risk Seeking
Wealth
The quantification of risk aversion is achieved with the calculation of the Arrow-
Pratt coefficient of absolute risk aversion (ARA), which refers to the curvature of
the utility function. This coefficient, is defined as follows:
(10)
For increasing, concave reflecting that the decision maker

prefers less uncertainty to more uncertainty, given the same EV. Risk aversion is
assumed to be constant when the multiplication of all outcomes by a constant
does not change the preference relation between the prospects.
Similarly, relative or proportional risk aversion (RRA) is given by which is

defined as:
(11)
The aforementioned risk aversion measures cannot represent a unique set of

risk preferences unless the utility function is assumed to be monotonic and
increasing. This assumption effectively states that the same ARA cannot
represent risk preference for and – at the same time.
24
Similar to the concept of an indifference curve, in finance the indifference price 10

is the value the decision maker assigns to a risky prospect. The expression of that
value in monetary terms is the risky prospect’s certainty equivalent. This
monetary value equivalent is often referred to as the risk premium, the certainty
equivalent or the compensation equivalent.
The risk premium (RP) is the amount that makes the decision maker indifferent
between a prospect L that will result in a wealth change of W + L, and a sure
prospect W – RP. In other words:
(12)
Where and ( )
Similarly, the Certainty Equivalent (CE) of the prospect is the amount that
makes the decision maker indifferent between W + L and W + CE. i.e.
(13)
Using Expected Utility symbolism, the CE is defined as:
(14)
The relationship between CE and RP is given below.
̃ (15)
A key product of CE is the Certainty Equivalent Factor (CEF)11, defined as

follows:
⁄̃ (16)
CEF is the fraction of a lottery’s expected value that bears equivalent value as the
certain outcome CE. In other words, it is the percentage discount in EV that
10Also known as reservation price or private valuation

11 Also known as the Certainty Equivalent Adjustment Factor or the Certainty Equivalent
Discount Factor.
25
uncertainty imposes on the subjective value of the prospect. In risk neutrality,

CEF=1.
Risk Tolerance (RT) is another measure of risk appetite and indicates the
extreme payout levels in the positive and negative domains that a decision
maker would accept. As RT increases, risk aversion decreases and the utility
function becomes flatter. These relationships are presented in the figure below.
Figure 2.3: Graphical Representation of the Certainty Equivalent
U(CE)
RP
W
The above analysis of utilities requires the assumption of a utility functional. This
is a prerequisite for most of the parametric evaluations that transform revealed
preference into meaningful inference of risk appetite. When the utility function is
unknown, the CE is defined as the certain amount that gives the same EU as the
gamble. In the absence of a confirmed utility functional, assumptions and
axiomatic restrictions on a hypothetical form bring substantial uncertainty and
complexity in the model. This problem emphatically reveals the need for an
efficient and effective means for a non-parametric estimation of implied risk
appetite; a target that this thesis pursues.
26
Chapter 3 - Theories of Risk and Financial Decisions
3.1 Normative vs Descriptive Theories
Stigler (1965) designates three criteria for the assessment of economic theories:
congruence with reality, generality and tractability. Unfortunately, the various
theories of economic decisions facing uncertainty compromise one or more of
the above criteria when taken in isolation. This sort of compromise is eliminated
when theories are applied in conjunction, each theory contributing towards the
multidimensional blueprint of financial decision making.
There is general consensus that the normative school of neoclassical economic

theory is and shall remain the point of reference, a departure point for deviations
from predicted behaviour. Complementary, and not mutually exclusive, is the
behavioural dimension which predicts the implicit and explicit pressures that
drive decisions away from rational predictions. A thorough understanding of the
reasons why deviations might occur leads to a hybrid theory of choice under
uncertainty along the lines of Stigler’s (1965) criteria.
A high level relationship between normative and behavioural theories is

presented in the figure below. In our view, normative theories in compliance
with the EU framework prescribe a rational decision process; descriptive
behavioural theories such as Cumulative Prospect Theory (CPT) explain
deviations from prescription; Both lead to predictive accuracy.
Figure 3.1: Prescriptive Theories of Economic Behaviour under Uncertainty
Normative Prescriptive Predicting Objectively

Theories (EU) Framework Rational Decisions
Behavioural Descriptive Predicting Subjectively

Theories CPT) Framework Rational Decisions
27
Chapter 3 Theories of Risk and Financial Decisions
Fundamental to the analysis of financial decision making is one of the pillars of

the rationality assumption, the assumption that decision makers are utility
maximisers. This assumption implies that decision makers rationally assess their
alternatives and choose the optimum prospect, from which they expect to derive
the maximum pleasure, satisfaction or utility. While rational EU maximisers are
assumed to apply a strict set of rules in their construction of preferences,
empirical evidence indicates substantial and consistent violations of EUT
predictions (Camerer, 1995; Starmer, 2000; Hershey and Shoemaker, 1985;
Rabin, 1998; 2000; 2002, etc.). These violations are often systematic (Starmer,
2000) and theoretical deviations reveal inconsistent preferences which cannot
be incorporated in traditional EU models (Hershley and Shoemaker, 1985;
Bleichrodt et al., 2001; Abdellaoui et al., 2007). To illustrate, EUT reflects
differences in people’s propensity to risk as differences in utilities: For the risk
averse individual, the aversion to potentially losing -€500 is greater than the
attraction of potentially winning €1,000, so he rejects a lottery with equal chance
towards either outcome, although the prospect has a positive expected value of
€250. Behavioural theories present various combinations of biases and
heuristics that explain the refusal of a favourable lottery. As will be discussed
later on, one such explanation is loss aversion which pertains to the fact that
people have a natural tendency to avoid losses, hence the observed avoidance of
losses even when faced with greater prospective gains. The underlying theory
incorporating loss aversion is Prospect Theory (PT), which postulates that the
decision maker evaluates the lottery in two stages: Editing and Evaluation.
During editing, the information is filtered and transformed according to the
subjective set of evaluators of the decision maker. The edited information is then
evaluated and a decision is made. Another theoretical explanation is that of
regret theory, which incorporates this sort of risk aversion as an aversion
towards a posteriori regret, i.e. towards the feelings that stem from ending up
with the least preferred outcome, in the aforementioned example -€500.
28
3.1.1 A Note on Rationality
“…For even if the event turns out contrary to one’s hope, still one’s decision was
right, even though fortune has made it of no effect: whereas a man acts contrary to
good counsel, although by luck he gets what he had no right to expect, his decision
was not any the less foolish”.
Herodotus VII: 1012
Central to any discussion on rational decisions is the difference between a

rational decision and a correct decision. While a rational decision is any decision
that can be justified with a series of expectations, evaluations and estimates,
many of which can be purely subjective, a correct decision is the decision which
in retrospect led to the achievement of the goal. As a result, a decision deemed to
be “rational” by common sense a priori, may or may not be proven to be
“correct” a posteriori. In other words, the rationality of a decision is what can be
assessed in advance, and the correctness of a decision can be assessed in
retrospect.
In consumer theory the analysis of choices over certain prospects incorporates

this distinction between rationality and utility maximization: A thirsty decision
maker faced with a consumption choice between water and apples will choose
water. A hungry decision maker faced with the same consumption choice will
choose apples. In fact, their choices will probably be the opposite after their need
for water and apples is satisfied, and change back when thirst and hunger arise
again. Preferences when dealing with consumption of goods and services usually
build on needs, wants and prior experience.
On the other hand, in the presence of financial risk a very different approach is
adopted. Under the assumption of rationality, when faced with a lottery-type
decision the decision maker’s decision will aim to maximize profits. However,
12«Σὺ ὦν μὴ βούλευ ἐς κίνδυνον μηδένα τοιοῦτον ἀπικέσθαι μηδεμιῆς ἀνάγκης ἐούσης, ἀλλὰ
ἐμοὶ πείθευ. νῦν μὲν τὸν σύλλογον τόνδε διάλυσον· αὖτις δέ, ὅταν τοι δοκέῃ, προσκεψάμενος ἐπὶ
σεωυτοῦ προαγόρευε τά τοι δοκέει εἶναι ἄριστα. τὸ γὰρ εὖ βουλεύεσθαι κέρδος μέγιστον
εὑρίσκω ἐόν· εἰ γὰρ καὶ ἐναντιωθῆναί τι θέλει, βεβούλευται μὲν οὐδὲν ἧσσον εὖ, ἕσσωται δὲ ὑπὸ
τῆς τύχης τὸ βούλευμα· ὁ δὲ βουλευσάμενος αἰσχρῶς, εἴ οἱ ἡ τύχη ἐπίσποιτο, εὕρημα εὕρηκε,
ἧσσον δὲ οὐδέν οἱ κακῶς βεβούλευται.» Translated quotation from Keynes, 1920 (A treatise on
probability, page 307)). Also in Peterson, 2009.
29
this intention does not necessarily lead to maximum profits. It simply states that
a rational decision is the decision that makes sense, at a specific point in time,
given the available information and circumstances of that specific point in time.
A correct decision is the decision which achieves the desired goal, and that can
only be assessed in retrospect. Therefore, a rational decision may not turn out to
be the correct decision, as it may fail to achieve the expected outcome. Likewise,
the correct decision may be an irrational decision which brings on the desired
achievement. As the correctness of a decision is revealed in the future, it is no
surprise that decision theorists focus on the rationality of the decisions rather
than their correctness (Peterson, 2009).
The distinction between a rational choice and the right choice is very similar to
the distinction between normative and descriptive theories of investment
decision making. Normative theories prescribe what economic behaviour should
be. Behavioural theories describe what economic behaviour might be. The
prescriptive framework of rational decisions (which may or not be correct, i.e.
achieve maximum payout or satisfaction), combined with the descriptive
framework of subjectively rational decisions (which also may or may not be
correct), is, in our view, the optimal handling in the analysis of preferences
among risky prospects.
3.2 A Brief History of the Analysis of Risky Prospects
The analysis of risk has progressed economic thought like no other concept ever
could. For a component of everyday life with on-going, significant presence in the
lives of ancient human communities, it is striking that a systematic approach to
risk was only established during the Renaissance. The incentives for the
prominent minds of the time to search for a better understanding of risk and
uncertainty came from two very different fields: religion and trade.
Until the 16th century, the future was very much a religious matter; people
attributed whatever happened to them to one or more gods, removing a
substantial amount of randomness from their projections for the future. In
western societies, as religion shifted towards self-reliance, the need for risk
management became profound. Concurrently, the emergence of trade, a risk-
30
bearing activity with manageable qualities, also imposed a better understanding

of risk, which soon led to the need for its systematic assessment (as well as to the
creation of the insurance industry).
3.2.1 The Emergence of Probability
Early theoretical approaches to risk were boosted by evolutions in mathematics

and calculus, such as the statistical approach to probability13 of Pascal and
Fermat during the 17th century. The concepts of expected value, or mathematical
expectation, emerged around that time, with aspirations to become a universal
method of assessing desirability, predicting preference and understanding
attitudes to risk.
In mid-18th century, the English mathematician Thomas Bayes proposed the

analysis of probability as a measure of belief rather than a frequency. He showed
that probability estimates are updated as new relevant information is received,
providing the mathematical result of correctly calculating conditional
probabilities:
|
|
| |
where is the complement set of . is the initial degree of belief in the

occurrence of outcome B. | is the posterior, i.e. the degree of belief in A
given the impact of B.
A century later, Bayes’ approach on updating probabilities became a reference

point for the development of neoclassical decision theory. Until today, “Bayesian
probability” refers to probabilities rationally updated according to available
information. In fact, Bayes rule of updating probabilities and the formalization of
probability by Ramsey (1926, 1931) two centuries later formed the theoretical
basis for the development of modern decision science. Bayesianism has come to
imply the subjectivity of probability and the neoclassical view that rational
decision makers are subjective expected utility maximisers (Peterson, 2009).
13Cardano’s work in the period 1525-1565 paved the path for odds and probabilities (Bernstein,
1996).
31
Back in the Renaissance, as thinkers familiarized themselves with probability

and risk, Expected Value (EV) was spreading as the definitive pricing mechanism
for risky prospects.
3.2.2 From Expected Value to Utility Theory
Utility was introduced in the 18th century along with philosophical empiricism,
stemming from the works of David Hume, John Locke, George Berkeley and
Jeremy Bentham (1748-1832). In fact Bentham and John Stuart Mill (1806-1873)
were the founders of the school of Utilitarianism, the ethical dimension of utility
according to which any action is morally correct only if it maximizes overall
wellbeing. Utility in financial decisions under uncertainty was introduced by the
Swiss mathematician Daniel Bernoulli (1700-1782) almost concurrently with the
neoclassical economics revolution of Adam Smith. Bernoulli (1738) replaced the
measurement of values with the measurement of utility and argued that “the
value of an item must not be based on its price, but rather on the utility that it
yields”14.
Bernoulli went on to define expected utility as the sum of the utilities of potential
outcomes weighted by their probabilities of occurrence - and introduced the
concept of marginal utility. According to the diminishing marginal utility
hypothesis, the utility of one unit of a good is smaller than the utility of ten items
of that good. Along the same lines, the utility of ten units of a good is not the
same as ten times the utility of that good. An extension of this principle is the so
called wealth or income effect. In Bernoulli’s words “(the) utility resulting from
any small increase in wealth will be inversely proportionate to the quantity of
goods previously possessed” 15. The diminishing marginal utility hypothesis also
extends to the assumption that when faced with a lottery-type decision, the
disutility of losses is larger than the utility of gains of the same value. Utility
assessment in risky prospects according to Bernoulli involves subjectivity and
relativity. The former refers to the personal assessment of the risks and of the
values at stake; the latter refers directly to the decision maker’s current wealth.
14 From Bernoulli’s (1738) book “Papers of the Imperial Academy of Sciences in St. Petersburg” -
Quotation cited in Bernstein (1996).
15 Full text available in http://math.fau.edu/richman/Ideas/daniel.htm
32
Overall, Bernoulli’s work placed the foundations for the evolution of economic
theory providing ground-breaking insight on decision making facing risk,
including investor behaviour, portfolio selection and risk management.
St Petersburg Paradox is a reference point in utility theory, as it is the illustration

of the failure of Expected Value as a measurement for risky prospects. The
paradox was composed by Daniel Bernoulli’s nephew, Nicolas Bernoulli, and
refers to the following game:
Suppose we repeatedly toss a coin until heads comes up, at which time the game
ends and its payout equals where = number of coin flips. The table below
summarizes the number of tosses and respective payouts of this game:
Table 3.1: St Petersburg Paradox Payouts 16
No of Tosses Payout in Ducats

1 1
2 2
3 4
4 8
5 16
… …
20 524,288
… …
30 536,870,912
A simple calculation of the expected value of this game points to infinity:
but the substitution of expected value with utility restricts the value of the game
to each decision maker’s subjective assessment. This simple transformation
produces a better approximation of the amount people would actually be willing
to bet to play this game. Bernoulli argued that people estimate the utility of
monetary payouts through a logarithmic function, as follows:
16 Thoroughly discussed in Samuelson (1977).
33
A key characteristic of this functional form is that it exhibits decreasing marginal

utility, providing a solution to St. Petersburg paradox. It implies that the amount
a decision maker would be willing to pay is a function of his current wealth .
By extension, the assessment of the prospect by the decision maker is based on
the change in that the lottery brings. Bernoulli concluded that if the lottery is
offered at a finite price then the expected utility of the lottery becomes finite
as follows:
( )
∑
where is the expected change in utility, W is current wealth and is the

price of the lottery.
Bernoulli concluded that it is in fact utility, and not value, that determines the
price assigned to an uncertain prospect. He also argued that the intention of the
decision maker to assign a value below the EV to the prospect is evidence of risk
aversion. Finally, he predicted that the wealthier the individual, the higher the
price he would be willing to pay for the ticket.
The impact of risk and uncertainty in the analysis of profits, investment

decisions, consumer products, logistics, etc. in economic theory was
acknowledged throughout the 18th, 19th and 20th century by a number of
prominent economists like Fisher (1906), Edgeworth (1908), Knight (1921),
Keynes (1936, 1937) and Stigler (1939). A formalized approach to decisions
facing uncertainty was attempted by Hicks (1931), Makower and Marschak
(1938) and Tintner (1941) who distinguished between preferences over
probability distributions and preferences over certain outcomes. At the time, the
main debate was evolving around whether mean and variance were insufficient
for the determination of risk ordering. The incorporation of risk and uncertainty
in economic models came some 200 years after Bernoulli’s breakthrough work
on the subjectivity of value.
34
3.2.3 Utility Maximization and Expected Utility Theory
Building on Ramsey’s (1931) use of probability distributions for the ordering of

risks, the axiomatic approach to the ordering of preferences was simplified and
refined by John von Neumann and Oskar Morgenstern (1944). In their book
Theory of Games and Economic Behavior they constructed the framework of
axioms according to which rational decision makers choose in order to maximize
their utility. Their work formed the benchmark for decision making in
neoclassical economics and finance, and remains until today the point of
reference for new and emerging theories of choice.
The theory of von Neumann and Morgenstern (hereafter vNM) begins with the
assumption that decision makers are rational utility maximisers. Expected Utility
Theory states that when faced with risky or uncertain prospects, the decision
maker perceives these prospects as utility values multiplied by the probabilities
attached to them and compares them accordingly in order to choose among them
the one that maximizes his/her utility. vNM’s axiomatization assumes that when
preferences are complete, continuous, monotonic, transitive and independent,
they can be incorporated in a well-defined utility function the maximization of
which predicts rational choice among risky prospects. Extensions of these
properties are invariance and dominance17.
A subjective dimension - in a way, the “personalization” of decisions - came soon

after vNM’s breakthrough and within the EUT framework, but with minor
adaptations to fit different economic perspectives: Savage (1954) in
“Foundations of Statistics” substituted probabilities with jointly determined
subjective probabilities, further enhanced with Anscombe and Aumann’s (1963)
work towards what is known as Subjective Expected Utility (SEU) theory 18. SEU
provides the framework within which jointly determined subjective probabilities
take the role of objective probabilities (Kim, 1991). Indeed the subjective
extensions of EU have become the benchmark for the theory, and as Barberis and
Thaler (2005) mention:
17 See also Shapiro (1979).

18 Henceforth EU and SEU are used interchangeably.
35
“Rationality means two things. First, when they receive new

information, agents update their beliefs correctly, in the
manner described by Bayes’ law. Second, given their beliefs,
agents make choice that are normatively acceptable, in the
sense that they are consistent with Savage’s notion of Subjective
Expected Utility”
A notable extension to EU comes from Kenneth Arrow (1951), Gerard Debreu

(1959) and Daniel Hirshleifer (196519) who introduced the state-preference
perspective to EUT, essentially eliminating probabilities and substituting
monetary payouts with bundles of goods. The state-preference EU approach has
produced significant insight for the analysis of Walrasian and general
equilibrium analyses.
3.2.4 Contributions from Welfare Economics and Consumer Theory
Dominance states that for any two prospects A and B, if A is better than B in at
least one respect and A is equivalent to B in all other respects, then A should be
preferred to B. Invariance states that alternative presentations of the same
selection problem should lead to the same choice. The roots of these
assumptions are traced in welfare economics, especially Ronald Coase’s (1959)
theorem on efficient allocation. Coase’s paper on radio frequencies states that in
the absence of transaction costs, bargaining will lead to efficiency, even when
property rights are misallocated at the starting point. The proposition that the
starting point of the bargaining process is irrelevant and that efficiency will be
reached regardless, has extended to a wide variety of disciplines and theories,
including economics. In neoclassical economic theory, it translates to current
wealth or any other reference point being independent of the utility assigned to a
prospect. Invariance is also known as extensionality (Arrow, 1982) or
consequentialism (Hammond, 1986). Consequentialism assumes that decisions
are based on preferences over final consequences. It extends to the assumption
that initial wealth represents lifetime wealth when a decision is made. Another
extension of invariance is the reduction principle which implies indifference
between a multi-stage lottery and a single-stage equivalent.
19 Also in Hirshleifer (1966) and in Hirshleifer and Shapiro (1969).
36
The conventional neoclassical theory of consumer choice was established

primarily by John Hicks (1956) and postulates that individual preferences are
transitive, continuous, increasing and convex. Hicks identified the concepts of
Willingness to Accept (WTA) and Willingness to Pay (WTP), and suggested that
WTP is equivalent to the maximum amount of money (or quantity of a good) the
individual is willing to give up in order to acquire a specific item, and WTA is the
minimum amount of money (or quantity of a good) the individual is willing to
accept to give up a specific item in his possession. Hicksian WTA and WTP are
not assumed to be equal, and indeed is assumed, but the exact
magnitude of the divergence is an issue of debate. Willig (1976) shows that the
amount any decision maker is willing to accept to avoid a risky prospect must
approach the amount the decision maker is willing to pay to purchase the risky
prospect, and any difference between them is attributed to the income effect. He
refers to WTA as the “compensating” price and to WTP as the “equivalent” price
and argues that indifference curves are independent of current wealth levels. He
argues that any disparity can only be attributed to the income effect,
which, he notes, will account for a very small difference between the two prices.
He concludes that it ought to be irrelevant whether the WTP or the WTA method
is used, the answer should be the same20. Indeed, when income effects are
allowed for, conventional economic theory assumes that the maximum amount a
person would pay and the minimum amount a person would ask for to give up a
prospect is expected to be equal (Henderson, 1941, p. 121). Randall and Stoll
(1980) show that this divergence cannot be more than a few percentage points
when all entries in the decision problem are of non-definitive importance in
subjects’ lives. Hanemann (1991) argues that large disparities between WTA and
WTP can be expected with certain types of goods21. The observed disparity
between WTA and WTP exceeds the levels that neoclassical economics can
justify, in direct violation of traditional preference theory.
20Assuming small income effects

21Hanneman (1991, pg. 646) shows that the WTA vs WTP disparity can be expected when the
underlying choice problem includes public goods for which private consumption goods are
available
37
3.2.5 Early Observations of EUT Violations
As 20th century progressed, the concepts of rationality and utility maximization

penetrated most fields of decision making. In economics, the neoclassical school
painted a very precise picture of what came to be known as ‘Homo Economicus’,
a rational decision maker whose beliefs are updated using Bayes’ rule and whose
preferences are defined over wealth, aiming at utility maximization.
In a twist of fate, just as the St Petersburg Paradox marked the demise in the
application of the EV methodology in the measurement of preference, another
paradox constructed some two hundred years after Bernoulli’s reveals violations
in EU. Through a decision problem brought forward by French mathematician
Maurice Allais (1953) came the emergence of a new, behavioural dimension in
decision science. Allais’ paradox presented below documents that rationality
places tight restrictions on what perhaps requires multiple degrees of freedom.
It basically shows that the rationality assumption is often distorted by biases that
overweight probabilities, distort preferences and violate fundamental EU
assumptions, while compromising the descriptive and predictive value of the
theory.
By the 1960s the descriptive weakness of expected utility was exposed with
concurrent contributions, in the same direction with Allais’ (1953) seminal
paper, by Ellsberg (1961) on ambiguity aversion, Markowitz (1952a;b) on
portfolio selection and Pratt (1964) on risk aversion.
EUT predicts an objective, rational assessment of changes in probability, and the

correct application of Bayes’ law in their updating. Accordingly, the difference in
likelihood between a 99% and 100% chance to win €100 is the same as the
difference between a 9% and a 10% chance to win the same amount. Empirically,
significant contradictions are observed.
Maurice Allais (1911-2010), a French economist and Nobel Laureate, developed

a theory of cardinal utility concurrently to vNM’s EU. In 1953, he presented the
following problem to indicate violations in EUT.
38
Assume a choice problem between the two sets of lotteries in the table below:
Table 3.2: Allais’ Paradox
Set 1
Lottery A Lottery B
Payout Probability Payout Probability
$1million 89%
$1million 100% $0 1%
$5million 10%
Set 2
Lottery C Lottery D
Payout Probability Payout Probability
$0 89% $0 90%
$1million 11% $5million 10%
When asked to choose between Lottery A and Lottery B in Set 1, most

respondents choose Lottery A. When faced with Set 2, the same respondents
choose Lottery D. This means that in Set 1 respondents prefer the lottery with
the lower EV, but which contains no uncertainty. The respondents’ preference
reveals an aversion to risk, as they are willing to compromise their winnings to
avoid uncertainty. In Set 2, where both lotteries contain some level of risk, the
lottery with the higher EV is chosen. On the other hand, the lottery chosen offers
a 10% lower probability of winning, which is in contrast to the choice in Set 1.
This observation violates EUT as it states a contradiction: Subjects choose the

safer prospect in one set and the riskier prospect in the other set. The preference
pattern cannot be explained within the EU context – in fact the theory’s
descriptive shortcomings sparked four decades of academic work on alternative
theories seeking reliable predictive estimates. The school of behavioural finance
explains why such deviations might occur.
3.2.6 The Emergence of the Behavioural School
Behavioural economics is the section of economics that adds human psychology

to economic analysis as a means to understand, explain and predict deviations
from rationality. We can trace early concepts of behavioural economics as early
as in the works of Adam Smith (1759/1892) describing loss aversion, a key
concept in Prospect Theory; Jeremy Bentham, whose utility concept was tied to
39
psychology; George B. Selden (1912) who in his book Psychology of the Stock
Market wrote about “the belief that the movements of prices on the exchanges
are dependent to a very large degree on the mental attitude of the investing and
trading public”; Vilfredo Pareto who speculated about how human feelings and
thoughts intervened in economic decisions; and, of course, in the works of John
Maynard Keynes who made extensive references to the psychology of economic
decision making (as cited in Camerer and Lowenstein, 2004).
Along with significant breakthroughs in psychology, which was slowly

recognized as a science during the 20th century, on information-processing,
cognitive tasks, problem solving and decision making, the behavioural school in
economics emerged when prominent psychologists decided to merge
psychological and economic models. Among them, Amos Tversky and Daniel
Kahneman who introduced a psychological dimension to economic decision
making, where imperfect decision makers deviate from utility maximization.
Their insightful analysis of the economic behaviour that EU cannot predict,
explain or incorporate in its theoretical model, established the behavioural
school of economics and finance22.
In their 1973 paper Tversky and Kahneman introduced the availability

heuristic, “a judgmental heuristic in which a person evaluates the frequency of
classes of probability of events by availability, i.e. by the order with which
relevant instances come to mind”. In 1974 they wrote about the
representativeness heuristic and anchoring. Representativeness leads people
to pair objects that are similar or representative of each other. Tversky and
Kahneman (1974) provide a characteristic example of representativeness.
Subjects are presented with a description of Linda as follows:
“Linda is 31 years old, single, outspoken, and very bright. She majored in
philosophy. As a student, she was deeply concerned with issues of
discrimination and social justice, and also participated in anti-nuclear
demonstrations.
Please choose the most likely alternative:
22An overview of behavioural economics and finance can be found in Camerer et al. (2004), in
Thaler (2005) and in Barberis and Thaler (2005).
40
A. Linda is a bank teller

B. Linda is a bank teller and is active in the feminist movement”
Nearly 90% of subjects chose B as the most likely alternative, a choice that is
obviously not optimal as bank tellers who are active feminists are a subset of
bank tellers. Therefore, the choice of A bears a higher probability of being correct
than the choice of B.
A direct result of the representativeness heuristic is the cognitive bias known as

the gambler’s fallacy also referred to as the law of small numbers (Tversky and
Kahneman, 1971) which refers to the tendency of decision makers to expect
short random sequences to be representative of the probability distribution used
to generate them. In simple terms, it is the incorrect belief that the probability of
an occurrence is lower when the event has recently occurred, even in
circumstances where probabilities are independent. For example, consider a
series of coin tosses that yield the following results:
H, H, T, H, T, T, T
Assuming the coin is fair, what is more likely to come up next? Many subjects
exhibiting the gambler’s fallacy would answer that a Head is more likely to come
up next, as the last three tosses turned up Tails. This is, in fact, a wrong
assumption, as the chance for Heads and Tails is always equal to 50%.
The opposite of the gambler’s fallacy is the hot hand phenomenon which is the
belief that a non-autocorrelated series is positively serially autocorrelated. It
usually refers to a person’s skills, instead of the outcome of a gambling game.
Gilovich et al. (1985) examine the outstanding performance of basketball players
and their winning streaks. 91% of the subjects interviewed believed that a
professional basketball player had “a better chance of making a shot after having
just made his last two or three shots than he does after having just missed his
last two or three shots”.
Anchoring refers to the tendency to attach an estimate, value or price to a

readily available value or price. To illustrate I shall use an example from
Northcraft and Neale (1987). The experiment was conducted with real estate
41
agents who inspected a house and were given extensive information on location,
square meters, amenities, etc. Subjects were separated in four groups and each
group was quoted a different ask price. The group with the lowest ask price of
$119,900 gave an appraisal value of $114,000, while the group that was quoted
the highest ask price of $149,900 gave an appraisal value of $129,000. The same
experiment was conducted with non-professionals of the real estate industry,
and the anchoring effect was even larger with appraisal values at $117,000 and
$144,000 respectively.
Regarding the Allais paradox, Kahneman and Tversky’s explanation for

inconsistent observed preferences is the certainty effect, which leads to an
overestimation of the risk premium and refers to the fact that a small reduction
from certainty bears a greater effect to decision makers than the same reduction
from uncertainty to more uncertainty.
Other examples include the underweighting of unlikely outcomes, the

overweighting of probable outcomes, the discarding of outcomes that are
available in all prospects and the isolation of the differentiation components in
decision making.
3.3 Behavioural Theories of Decisions Facing Risk
The dismissal of a theory is not itself a theory. The analysis of economic

decisions facing risk required descriptively accurate foundations, which indeed
were found in behavioural science. Camerer and Loewenstein (2004) identify a
pattern in the scientific procedure applied in early behavioural economics and
finance research: Start with a well-established normative assumption, identify
anomalies, generalize the assumption to accommodate the anomaly and
construct a new model of economic behaviour. This is precisely the path that led
to the modelling of observed anomalies into a new, non-EU theory of choice
under risk and uncertainty. Behavioural economics emerged primarily as a result
of observed violations in expected utility predictions, so early research efforts
were very much based on experimental evidence such as the examples presented
in the previous section. With solid empirical foundations, a behavioural theory of
choice emerged to complement the neoclassical model. The prevailing
42
contributions of behavioural economics and finance to decisions facing risk are

primarily expressed in theories of reference dependence.
Reference-dependent preferences imply that the utility of an outcome depends

on comparisons of this outcome to relevant reference points or reference levels.
A brief history of the development of the reference-dependent methodology on
preferences is provided in this section. The most common assumption is that the
reference point in financial decisions facing risk is the status quo or current
wealth (eg. Kahneman and Tversky, 1992). Another approach is to consider
future wealth to be the reference point (eg. Koszegi and Rabin, 2009). Then there
are other suggestions, that depart from economics and expand into psychology
and sociology; for example, Neumark and Postlewaite (1998) analyse labour
supply and show that social comparison may set the reference point. Koszegi and
Rabin (2006) consider recent expectations about the outcome to be the
reference point. Often, recent expectations are the same as the status quo.
3.3.1 Prospect Theory
In 1979 Kahneman and Tversky presented their paper “Prospect Theory:

Decision Making Under Risk” where they analyse a series of violations of EUT
and introduced a theory that incorporates the psychological principles that
explain why these deviations take place. Prospect Theory (PT) essentially
permits descriptive deviations from rational choice theory, without
compromising theoretical tractability.
In PT value is extracted by gains and losses rather than final wealth positions,
and probabilities are transformed into decision weights. The value function, that
comes to replace the utility function of vNM, is defined using deviations from a
reference point so Prospect Theory is, contrary to EUT, a reference-dependent
theory. In terms of risk appetite, the theory assumes risk aversion when faced
with gains and risk seeking when facing losses.
The theory relaxes some of the EU axioms to promote descriptive accuracy, and
takes the form:
43
( ) (17)
PT postulates that preferences between risky prospects are not linear in

probabilities. As indicated in the figure that follows, the value function is concave
for gains and convex for losses, reflecting the aforementioned change in risk
appetite from risk aversion when facing gains to risk seeking when facing losses.
Figure 3.2: A PT Value Function

Value
Losses Gains
According to PT, prospects are evaluated in two stages, namely editing and
evaluation.
Editing comprises:
 the coding of outcomes as gains and losses, where payouts are inherently
ranked into desirable and undesirable scenarios,
 the combination of prospects with identical outcomes, where grouping
simplifies cognitive processing, leading to a better understanding of the
outcomes,
 the segregation of the riskless outcome, transforming risk perception and
formulating risk preference, and
 the cancellation of common components across the prospects, yet another
heuristic that simplifies cognitive processing.
44
Evaluation comprises:
 the transformation of probabilities into decision weights, a fundamental

component in the construction of preferences, and
 the transformation of payouts into a value function that is concave for
gains and convex for losses.
Loss aversion is the term used by Tversky and Kahneman (1991) to describe
the assumption that “losses and disadvantages have greater impact on
preference than gains and advantages”. The assumption of loss aversion is the
reason why the value function presented above is steeper for losses than for
gains.
The principal idea of loss aversion is by no means a new concept23. Adam Smith
(1892, pg. 311) in ‘The Theory of Moral Sentiments’ mentions that “we suffer
more… when we fall from a better to a worse situation, than we ever enjoy when
we rise from a worse to a better”. In terms of preference theory, loss aversion
was formally defined in Kahneman et al. (1990) as an explanation of the
observed difference expressed in the ratio of willingness to pay and willingness
to accept prices, a phenomenon they call the endowment effect (discussed
extensively throughout this analysis).
Moreover, due to loss aversion the gains function is usually different from the
losses function. The concept of loss aversion is an extension of Prospect Theory’s
assumption on the disproportionate handling of gains and losses around a
reference point, presumably the status quo.
The PT value function features a kink at the origin and the ratio of the slopes at
that point measures loss aversion. Empirical estimates of loss aversion measure
it around the level of 2, extending to the conclusion that the disutility of a loss is
twice as intense as the utility of a gain (Kahneman et al., 1990; Tversky and
Kahneman, 1991).
In Kahneman and Tversky (1979) loss aversion is – with

the mean or median being the loss aversion coefficient. Other definitions of the
23 See also Schmidt and Zank (2005).
45
loss aversion coefficient have been proposed in prior literature and Abdellaoui et
al. (2007) provide an overview, as presented in the table below. Theoretical
definitions of loss aversion are also available in Neilson (2002) who detects loss
aversion when for all and in Bowman et al. (1999)
who define loss aversion as for all .
Table 3.3: Loss Aversion Coefficients
Study Definition Domain Estimates

Fishburn and Kochenberger (1979)24 ⁄ Money 4.8
Tversky and Kahneman (1992) ⁄ Money 2.25
Bleichrodt et al. (2001) ⁄ Health 2.17 / 3.06
Schmidt and Traub (2002) ⁄ Money 1.43
Pennings and Smidts (2003) ⁄ Money 1.81
Booij and van de Kuilen (2006)25 ⁄ Money 1.79 / 1.74
Source: Abdellaoui et al. (2007)
Finally, Benartzi and Thaler (1995; 1999) apply the principle of loss aversion to
wealth management. They analyse portfolio monitoring frequencies and
particularly refer to the observation that the longer the investment horizon of an
investor, the more risk the investor is willing to undertake. They refer to it as
“myopic loss aversion”.
A non-parametric approach to the estimation of loss aversion by Gachter et al

(2010) is the extraction of WTA and WTP prices and the calculation of their ratio,
in other words a measure of the endowment effect. They confirm the findings of
parametric approximations, which indicate that preferences can be analysed
without the assumption of a specific functional form. As most of the parametric
calculations of loss aversion are linked to a utility function, various limitations
are imposed when a utility function is unknown, as is usually the case. Non-
parametric calculations of loss aversion may incorporate some problems of
tractability and generality. To compensate, they remove substantial complexity
and confusion from the analysis.
24This definition is also adopted in Wakker and Tversky (1993) for all x>0.
25This definition was introduced by Kobberling and Wakker (2005) as an adaptation of an earlier
suggestion of Benartzi and Thaler (1995). Booij and van de Kuilen (2009) use different loss
aversion coefficients for high and low monetary amounts. Our source, Abdellaoui et al. (2007)
quote the 2006 article of Booij and van Kuilen, I refer here to their publication of 2009.
46
In terms of probability assessment, Prospect Theory assumes the transformation

of probability to incorporate biases and heuristics that depart from objective
assessment. The resulting perceived probability distribution, as indicated in the
graphical representation below, overestimates and underestimates how
“probable” each “possible” outcome is. This assumption alone is enough to
provide a better descriptive fit for PT as compared to normative assumptions.
Figure 3.3: Α PT Weighting Function
1
π(p)
0 p 1
Prospect Theory, much as it has revolutionized economics of choice, is not
without functional fault. As noted by Fishburn (1978) and Kahneman and
Tversky (1979), the transformation of probabilities implies violations of
stochastic dominance. The value function of PT allows for the stochastically
dominated prospect to have a higher value than the dominant prospect, leading
to a substantial contradiction. Quiggin’s (1981; 1982; 1993) Rank-Dependent
Expected Utility (RDEU) or Anticipated Utility Theory solves this problem, by
employing cumulative rather than separable decision weights, thereby creating
rank-dependent subjective probability weighting and allowing non-linear utility
functions. The theory basically examines preference without the independence
condition, an approach also found in Machina (1982; 1987), Holt (1986), Segal
(1987; 1988; 1990) and Karni and Safra (1987).
47
RDU points to a generalized EU theory with tractable properties that make it

suitable for economic analysis (Cox and Sadiraj, 2008). Utility takes the following
form:
∑ ,
Where is the vector of outcomes, is the vector of probabilities and with the
following terms for the probability weighting vector:
∑ ∑ ( )
Where is a function that transforms probability and is a function that

transforms value. For two outcomes , with the weighting vector is
where is the function determining the weight of the
high outcome. When people overweight the low outcome, This
means that when people overweight the low outcome, the perceived probability
is smaller than the actual probability .
In RDU decision weights depend on the ranking of the outcomes. In Quiggin’s

model RDU and EU co-exist and EU is a special case of RDU, when . This
is the case where probability is neither over-, nor under-weighed. Thereby, the
dichotomy of whether to accept or reject the rational school paradigm is
compromised. Moreover, through probability weighting the methodology
essentially allows preferences to depend on the rank of the final outcome (Yaari,
1987).
3.3.2 Cumulative Prospect Theory
Cumulative Prospect Theory (CPT) is an improved reference-dependent model of

choice, presented in Tversky and Kahneman (1992). Building on PT principles,
CPT applies the probability weighting function to the cumulative distribution
function as follows:
with
48
and takes the form:
∑ (18)
As in the original prospect theory, value is extracted from gains and losses, and
not final wealth levels, and, again, loss aversion is assumed. The difference is that
while PT accommodates the overweighting of low probabilities and high
probability changes bear more impact than low probability changes, in CPT the
decision maker is assumed to overweight the tails of the probability distribution,
thus preserving preferences for lottery-like gambles. This is achieved by the
model’s assumption of transformation of cumulative - rather than individual -
probabilities, because the decision weight depends on the cumulative
distribution of the lottery and not on the individual probabilities.
According to Tversky and Kahneman (1992) the functional forms for the CPT
value function, calibrated to their experimental findings, becomes:
{ (19)
where α represents risk aversion, λ represents loss aversion and
(20)
In Tversky and Kahneman’s (1992) experiment the above equations give the
following estimates:
, and reflects risk aversion and equals 0.61 for gains and
0.69 for losses.
Tversky and Kahneman’s estimate of α implies an S-shaped value function, an

assumption confirmed by a number of other researchers, for example in Baucells
and Heukamp (2006). By extension, the assumption of concave utility for gains
and convex utility for losses is brought forward. The concavity of gains is
confirmed in Camerer and Ho (1994), Wu and Gonzalez (1996) and Stott (2006).
49
All of these estimations presuppose a parametric form for probability weighting.

Gonzalez and Wu (1999) reject this specification in their sample analysis.
Wakker and Tversky (1993) and Tversky and Wakker (1995) exclude
probability weighting and base their preference condition on a cardinal utility
index. The independence of this index from probability weighting is confirmed in
Schmidt and Traub (2002).
Overall, the contribution of the CPT value function to financial decision theory is
three-fold:
a) It incorporates reference dependence whereby value is driven by gains and

losses relative to a reference point.
b) It reflects loss aversion, i.e. a steeper reaction to negative vs positive payouts,
c) It displays diminishing sensitivity, and the marginal value of gains and losses
decreases with size.
Tversky and Kahneman’s original 1979 paper in Econometrica is now one of the
most cited papers ever published, and Prospect Theory earned Daniel Kahneman
the Nobel prize in economics for 2002.
The key difference between the rank-dependence of RDU and reference-

dependence in CPT is that utility is defined over gains and losses around a static
reference point, rather than wealth positions incorporating the decision.
Moreover CPT, as opposed to RDEU, has different weighting functions for gains
and losses. Rubinstein (2006) suggests that total wealth is excluded from the
utility function and that changes in wealth should be included instead. Cox and
Sadiraj (2006) propose the division of utility that comes from wealth and the
utility that comes from risky outcomes. They argue that although bounded utility
applied to the utility functional is necessary to avoid St. Petersburg type of
paradoxes, it implies implausible risk aversion.
50
3.3.3 Post-CPT Models of Reference-Dependence
Arrow (197126) shows that when risks are small, risk appetite approximates risk
neutrality and utility maximizers with a differentiable utility function will always
want to participate in a risky prospect with positive expected value. His
definition of risk aversion implies that absolute risk aversion declines as payout
increases. Rabin (1998; 2000) and Rabin and Thaler (2001) note a profound
violation of Arrow’s assumption within the EU framework: When preferences
display risk aversion for small and moderate stakes, then outrageous degrees of
risk aversion are assumed for large stakes. Rabin discusses the following
favourable lottery:
(21)
A similar example is provided in Barberis et al. (2006) who offer the following
lottery to a sample of MBA students, financial analysts and wealthy investors:
They report that 71% of the subjects turned down the gamble.
Effectively, if risk aversion is consistent for the same subjects across all
experiments, then the same subjects who turn down , would effectively reject
even chance bets of losing $1,000 and gaining any amount (such as an even
chance to win $500,000 and lose $1,000), exhibiting implausible levels of risk
aversion. In his famous calibration theorem, Rabin (2000) shows that in order to
avoid extending to extraordinary levels of risk aversion in higher stake
prospects, a behavioural model of reference dependence must be used to
accommodate such cases. He essentially argues that the same utility of money
cannot be used for both small and large stakes.
Although the intuitive solution to Rabin’s (2000) calibration problem would be

the use of a first-order risk averse (FORA) utility specification, such as RDEU,
Safra and Segal (2008) expand Rabin’s calibration problem to other non-EU
models, marking the beginning of an on-going debate as to the solution of the
26 Page 100
51
problem. The main conclusion of Safra and Segal is that constant risk aversion
and consistent preferences are two unrealistic assumptions that lead to
significant descriptive diversions for many EU and non-EU theories. They also
show that when uncertainty is created by other sources of risk other than the
prospect at hand, then even FORA utility functions exhibit Rabin’s calibration
problem.
This observation incorporates an important challenge for financial economics as

the assumption of consistent risk preferences is an integral part of many
empirical setups. In fact, as Neilson (2001) notes, this is an inherent weakness of
rank-dependence as well as EU. LeRoy (2003) criticizes Rabin and challenges the
descriptive accuracy of the calibration theorem, arguing that investors maintain
portfolios in risky assets offering far worse expected payouts than Rabin’s
assumptions. Rubinstein (2006) is also sceptical about Rabin’s dismissal of EU as
inaccurate. She declares her doubt that “there is any set of assumptions that does
not produce absurd conclusions when applied to circumstances far removed
from the context in which they were conceived”. In fact, this is an argument that
might well defy LeRoy’s criticism of Rabin as well.
Koszegi and Rabin (2006) introduce their model of reference-dependent

preferences with the following remark:
“How a person assesses the outcome of a choice is often

determined as much by its contrast with a reference point as by
intrinsic taste of the outcome itself. The most notable
manifestation of such reference-dependent preferences is loss
aversion: losses resonate more than same-sized gains”.
The central assumption of reference dependence is that preference depends not

only on the prospect utility, but also on a reference point R.
The Koszegi and Rabin (2006) model builds on CPT and Sudgen’s (2003)
Reference Dependent SEU to promote a general version of the model:
52
Let | be a riskless outcome with being the payouts and

the reference level of the payouts. Assuming linearity in
probabilities, if is drawn according to the probability measure , then:
| ∫ |
Assuming a stochastic reference point, for example the probability measure G,

with drawn according to the probability measure F, then:
| ∬ |
To illustrate, assuming the reference lottery is a gamble between €0 and €100,

an outcome of €50 feels like a gain relative to €0 and like a loss relative to €100.
As a result, utility depends on both the reference lottery and the actual outcome.
The problem with reference-dependent models of preference is that their

validity depends on which reference point is chosen. Koszegi and Rabin (2006)
propose that the reference point is the ultimate choice. Koszegi (2010) suggests
that the personal equilibrium of a decision maker is given by .
If this preference relation holds, and is the chosen reference point, then the
Koszegi-Rabin model assumes that if
and that is given by the relationship:
∑ ∑
where is a transformation of utility and is assumed to be increasing with

.
The trade-off for the descriptive accuracy of non-EU theories is that as some
reference-dependent theories correct violations in first-order stochastic
dominance, they incorporate violations of transitivity. Numerous axiomatic
variations of CPT have emerged in recent years. One example is regret theory
which relaxes the transitivity assumption (Loomes and Sudgen, 1982; Fishburn,
1985) and overcomes this problem. Still, CPT remains the strongest alternative
of EU for the resolution of the descriptive failures of the rationality assumptions.
53
Chapter 4 - Empirical Research on Risky Preferences
Empirical research on financial decisions facing risk often suffers from inherent
limitations and sample biases. For example, data on investor preferences drawn
from groups of decision makers with actual investment experience is scarce.
More commonly, the subjects are economics or psychology students, with limited
or no investment exposure and low income levels.
The efficient motivation for the elicitation of truthful, realistic answers usually
bears a high cost which renders it restrictive and urges researchers to either use
hypothetical payouts or use real payouts but of very small amounts. Moreover, a
plethora of biases has been documented in the literature and most of them are
point to the discrepancies of normative or descriptive theories of choice.
A comprehensive overview of the elicitation procedures used in the field is

available in Harrison and Rutstrom (2008). Throughout this Chapter I present a
brief overview of ranking and CV methods commonly used for the analysis of
risky prospects, and review relevant empirical studies on preferences among
risky prospects. Emphasis is placed on risk aversion and the level of prospective
payouts, loss aversion and the endowment effect. A combination of various
methods and their direct comparison can produce good approximations of true
risk preferences, which published research often fails to record.
4.1 Experimental Techniques
The experimental methods used to extract preferences among risky prospects

are presented in the sections that follow. Elaborate discussions on the subject
are available in Harrison and Rutstrom (2008) who provide a thorough overview
and in Dave et al. (2010) who provide an insightful comparison of methods.
4.1.1 Auctions
Auctions are techniques that employ various pricing tasks to reveal the certainty
equivalent of risky prospects. Their main advantage is that they provide ample
54
Chapter 4 Empirical Research on Risky Preferences
motivation for subjects to respond truthfully. On the other hand, auction

techniques might suffer from biases related to competition and game theory
which often cannot be controlled, predicted, isolated or fully incorporated in any
analysis.
First Price and Vickrey Auctions are auctions where the highest bidder wins are
called First Price auctions. Vickrey auctions (Vickrey, 1961) are auctions where
the highest bidder wins, but the price is determined by the second bidder. They
are therefore often called second-price auctions. Research has shown that in
both Vickrey and first price auctions subjects tend to overbid (Kagel et al., 1987;
Kagel and Levin, 1993).
Another important auction methodology is the Becker-DeGroot-Marschak (BDM)

method, where subjects are offered a lottery ticket and asked to state a minimum
selling price to part with it, in other words to self-determine their certainty
equivalent. Then a random price is drawn for that lottery and if that price is
higher than the subject’s CE, then the subject sells his ticket for that higher
amount. If the random price is lower or equal to the subject’s CE, then the subject
plays the lottery. The technique was introduced by Becker, DeGroot and
Marschak (1964), hence its name, and was modified by Harrison (1986; 1990)
and Loomes (1988) to serve as a measure of risk aversion. A discussion on the
main weaknesses of the implementation of this technique is available in Harrison
and Rutstrom (2008).
Wertenbroch and Skiera (2002) report that bids from an auction mechanism
were greater than WTPs drawn from hypothetical choice tasks. They note that
although both in BDM and in the Vickrey auctions the highest bid determines
who will buy the item, the price is determined through some other mechanism
and therefore they expect no overbidding. On the other hand, Noussair et al.
(2004) found that the Vickrey auction produces a better approximation of the
true WTP for private goods more rapidly than the BDM. BDM studies examining
the WTP/WTA disparity are presented in Gachter et al. (2010) and in Plott and
Zeiler (2005). The latter show that misconception is an important driver for the
gap between stated buying and selling prices (i.e. the endowment effect). Similar
55
results are reported in Halevy (2007) leading to some considerations on the

complexity of BDM, which requires subjects to complete tasks that may be too
challenging in cognitive terms. Further criticism on the BDM procedure comes
from Braga and Starmer (2005) who underline the method’s vulnerability
towards strategic behaviour among the subjects.
4.1.2 Ranking Tasks
One example of ranking experiments is Multiple Price Lists (MPL). They present
subjects with series of prices and asks them to choose the price or price range
they prefer. The method was introduced in Miller et al. (1969) who present
subjects with a series of binary lotteries and ask them to choose which one they
would like to play. The method is also used to elicit risk attitudes in Binswanger
(1980), Murnighan et al. (1988) and Holt and Laury (2002); to extract
Willingness to Pay (WTP) in Kahneman et al., 1990; to elicit individual discount
rates in Coller and Williams (1999). Northcraft and Neale (1987) use the MPL
method in a real estate experiment examining anchoring effects.
Nevertheless, Andersen et al. (2005) identify three disadvantages of this method,

namely:
a. Responses are in intervals, allowing for some anchoring effects

b. Respondents can change their responses at any time, leading to
inconsistencies
c. Framing effects are amplified when pricing is readily available, if not
“imposed” on the subjects.
Another technique is Random Lottery Pairs (RLP). This technique asks subjects
to choose between pairs of lotteries, several times. Subjects are then allowed to
play one of the chosen lotteries, usually selected at random. The technique was
initially designed to test EUT assumptions and to estimate utility functions.
Indicatively, the technique was applied in Hey and Orme’s (1994) experiment
where subjects were asked to choose or express indifference between over 100
pairs of lotteries, with various probabilities and payouts. At the end of the
experiment, a pair was chosen at random and subjects were offered the
56
opportunity to play their preferred lottery out of the chosen pair. The
experiment was repeated a few days later, with the same subjects and lotteries,
but presented in a different order. Prospects were presented in pie charts to
facilitate subjects’ perception of the probability distribution. They conclude that
behaviour can be reasonably well modelled as ‘EU plus noise’.” And continue to
note: “Perhaps we should now spend some time on thinking about the noise,
rather than about even more alternatives to EU?”. This is precisely our view on
the subject.
Other applications of this method are available in Camerer (1989), Battalio et al.
(1990), Kagel et al. (1990), Loomes et al. (1991), Harless (1992) and Harless and
Camerer (1994). The main advantages of the RLP method are that it is simple
and direct, subjects can usually understand what is required quite easily and an
incentive for truthful answers is provided as the subjects will be offered to play
one of the chosen lotteries. The drawback compared to MPL is that is does not
provide sufficient information about risk appetite (Harrison and Rutstrom,
2008). The resulting data serves for the construction of ordinal, instead of
cardinal, preferences.
Finally, the Ordered Lottery Selection (OLS) method presents subjects with a set
of prospects and asks them to rank them in order of attractiveness. This method
is often applied for the extraction of risk attitudes, for example Binswanger
(1980; 1981). He shows that as payouts increase, risk aversion increases, using
real payouts and asking subjects to choose out of eight lotteries. The same
technique was also applied by Murnighan et al. (1988) in order to divide the
subjects into risk averse and less risk averse groups. Other researchers using the
method are Barr (200327) and Eckel and Grossman (2002; 2008), again with a
view to measuring risk attitudes.
While the method is quite accurate and precise, the amount of information it can
reveal is limited. However, when accuracy in simple tasks is preferred versus
less accuracy in more challenging tasks, OLS generally produces good
estimations of risk appetite.
27Barr focuses on the impact of trust in rural Zimbabwean communities, but in doing so he
provides a good illustration of the OLS methodology.
57
4.1.3 Hybrid Methods
The most popular hybrid method applied to preference experiments is the

Trade-Off Method. Each subject is presented with dynamic lotteries which are
endogenously defined in real-time by the subject’s own responses and the
certainty equivalent for each lottery is elicited. The technique was introduced by
Wakker and Deneffe (1996) and was extended by Fennema and van Assen
(1999) to accommodate losses, by Abdellaoui (2000) and by Bleichrodt and
Pinto (2000) to elicit probability weights after utilities have been revealed.
Subjects are presented with two lotteries as follows:
for which is a very small

amount or zero and and are some fixed probabilities. The subjects are
asked to determine an amount such that they are indifferent between the two
lotteries. Then they move on to the second stage, where they face the following
two lotteries:
using the amount as stated in phase 1. If the subject answers truthfully, then it
can be inferred that:
As a result, when ,
The main advantage of this method is that it reduces the impact of the
probability distribution. On the other hand, as Abdellaoui et al (2007; 2008)
mention, the trade-off method cannot measure utility for gains and losses
simultaneously, which is a fundamental prerequisite for the estimation of loss
aversion. Another important problem is that subjects are not offered an incentive
to provide realistic, truthful answers and may be prompted to inflate their stated
value of Moreover, with this method a few more questions must be added
and presented to the subjects compared to the aforementioned methods.
Notwithstanding all of the above, when combined with incentive schemes, this
58
technique is promising in the sense that it allows for a very good approximation
of true certainty equivalents and incorporates a cross-check mechanism that
improves its reliability. In fact, as discussed in the methodology section later on
in this thesis, this technique can be modified to incorporate incentive
compatibility and improved reliability of results.
4.2 Experimental Methods for the Extraction of Preference
Wakker and Deneffe (1996) identify three utility elicitation methods: scaling,
certainty-equivalent methods and probability-equivalent methods. Holt and
Laury (2002) distinguish between two prevailing methods for the extraction of
preferences among risky prospects: contingent valuation and rankings.
In scaling methodologies, subjects are asked to assign ranked values to each of a

series of prospects. These ranking tasks contain a wealth of information
regarding ordinal preferences and are quite simple to extract. The drawback of
this technique is primarily that it does not correspond to a specific theoretical
justification.
Probability-equivalent methods require that subjects assign a probability to each

payout, such that the risky prospect becomes attractive to them. In both
cognitive and procedural terms, this method requires a grasp and familiarity
with the concept of probability that does imply some restrictions on the sample
selection. Similar cognitive limitations restrict the usefulness of lottery-
equivalent methods, introduced by McCord and de Neufville (1986).
Certainty equivalent (CE) or pricing methods are contingent valuation methods

whereby subjects are asked to state the certain value that bears the same
attractiveness or desirability to them as the risky prospect (Harrison, 1996). The
roots of contingent valuation, in fact, date back to Kaldor (1939) and Hicks
(1939). While the Kaldor-Hicks measure is not a measure of utility or welfare, it
transforms the effects of a decision into monetary values, rendering preferences
comparable across subjects and across prospects. In Hicksian terms, the
“compensation” and “equivalent” measures translate to what today is widely
applied in contingent valuation methods as the WTP and WTA prices.
59
Horowitz and McConnell (2002) summarize the methods used for the elicitation
of the Certainty Equivalent of risky prospects in the figure reproduced below. In
practical terms, one might find that the extraction of certainty equivalents is not
as separable as the figure above suggests. In fact, any empirical collection of
stated preferences should confirm the findings of an experiment, and vice versa.
When stated preferences and revealed preferences are not in agreement,
anomalies are detected.
Figure 4.1: CE Elicitation Methods
Market
Research Laboratory
Revealed
Preference Experiments
Experiments
Field
Experiments
Certainty Equivalent
Approximation
Direct Surveys
Stated
Preference
Indirect
Surveys
Source: Horowitz & McConnell (2002)
4.2.1 Experimental Settings
The choice of the environment through which data was originated is not doubt
one of the key features of any experiment. The observation of an event arising
with no intervention from the experimenter is a natural experiment. Natural
experiments collect information about the variables in a system and attempt to
isolate any interference in retrospect. In finance, an example of natural data is
the extraction of historical prices from the stock market and the analysis of this
data. The information contained in the prices includes noise and miscalculation,
hedging and speculation, institutional and individual investor positions, currency
fluctuations and macroeconomic impact, all recorded and incorporated in
60
historical price movements. In order to extract information on one of the

variables in isolation, researchers need to determine the correlations between
the variables and remove the impact of biases, noise, economic environment, etc.
from their observed data. The effectiveness of the data set depends on the level
of correlation of the variables, and, in general, the less the correlation, the better
the reliability of the data.
Controlled experiments, on the other hand, are experiments set in controlled

environments such as laboratory experiments, where researchers control some
or all of the surrounding conditions, including the decision tasks 28.
Finally, hybrids between natural and controlled experiments are partially

controlled experiments, often referred to as quasi-experiments. They are natural
experiments with some controls on the variables. A widely researched set of
hybrid data on risky preferences is drawn from TV shows. Such analyses are
presented in Bombardini and Trebbi (2005) and Blavatskyy and Pogrebna
(2006) who draw experimental evidence from the TV show “Affari Tuoi”, also
known as “Who Wants to be a Millionnaire”29. Similar data is drawn from the TV
game “Deal or No Deal”30 in experiments by Post et al (2008), de Roos and
Sarafidis (2006), Blavatskyy and Pogrebna (2006; 2008) and in Mulino et al.
(2006). Similar studies on other game show evidence have been carried out by
Metrick (1995), Gertner (1993) and Beetsma and Schotman (2001).
The inherent experimental benefits of such games include simple decision

problems between equi-probable prospects, reduced wealth effects and truthful,
thoughtful answers guaranteed by one-off, real payout decisions. The
shortcomings, on the other hand, are significant. Firstly, the decision problems
are partially ambiguous (known probabilities, but variable amounts and EVs)
which leads to computational limitations, variable risk and potential sequential
effects that could intervene with behaviour. Secondly, win-only prospects could
28 Several such experiments are described in the section that follows, as this thesis is based on
evidence collected through a controlled experiment.
29 The data reveals valuable evidence on risk preferences, as it contains both small and large
stakes, and real payouts of magnitudes that very few researchers could afford (up to €1m).
30 Subjects in the TV show “Deal or no deal” are presented with choices between boxes containing
various unknown amounts, ranging from €1 to €500k, and a certain payout.
61
lead to risk-seeking behaviour, as subjects have nothing to lose but their

opportunity costs. Thirdly, sample bias could be assumed on the premises that
people who choose to participate to TV shows are of a certain disposition and
character.
4.2.2 The Impact of Payouts
The impact of payouts in experiments involving lotteries is twofold. Firstly, they

can induce motivation for truthful, attentive answers that reveal true
preferences. Secondly, the level of the payouts bears a subjective significance
which may affect risk appetite.
One fundamental distinction is the use of real versus hypothetical payouts.

Empirical research on risky choice with monetary outcomes usually involves
lotteries of the form presented in equation (1) and asks subjects to rank or price
them, thereby revealing their preference. Experiments using actual lotteries
contain an inherent incentive, namely the opportunity to win the prospective
payouts, so the potential payouts motivate truthful answers. The level of the
payouts is, obviously, definitive and determines the strength of that incentive.
For example, a prospect with a chance to win €1 may be considered with
indifference and may not be given the same thought as a prospect with a chance
to win €100,000. Similarly, the chance to lose -€1 will not be met with the same
aversion as the chance to lose -€100,000.
On the other hand, when a prospect is hypothetical, the effect of the payout is
diminished to an imaginary “what-if” scenario. Hypothetical payouts obviously
lack the incentive inherent to real payouts. As in hypothetical settings subjects
might be demotivated to participate, especially in experiments carried out in
university laboratories with students invited as subjects, researchers offer a
participation incentive in the form of a participation fee. While that sort of
compensation, however low, offers motivation for participation, it has little
impact on the truthfulness of the revealed choice.
However, experiments offering real payouts might result in some sample bias, as
voluntary participation will indicate an appetite for gambling. Moreover, real
62
payouts are not always possible due to budget restrictions and due to the ethical
limitations of asking participants to risk incurring actual losses. As a result, very
often experiments are conducted using hypothetical lotteries, asking subjects to
state what they would theoretically choose if and when presented with
particular choice problems.
Hertwig and Ortmann (2001) review publications in the Journal of Behavioral

Decision Making over 10 years and report that in a total of 186 experimental
studies, only 26% used financial incentives. In fact, Ortmann and Hertwig (2006)
question the effectiveness of monetary incentives in certain research contexts,
but offer a rather weak set of arguments to support the redundancy of real
payouts, especially for the purposes of financial research. Indeed, contrary to
other disciplines which are less strict in their handling of hypothetical data, in
economics research with real payouts is generally preferred, as truthful and
accurate data collection is paramount (Kagel and Roth, 1995).
Some of the most widely cited works in the field drew their samples from
developing countries, where amounts that in the Western World are considered
insignificant, are significant. For example, Binswanger (1980;1981) draws his
sample from rural India. In his experiment prospect payouts exceeded the
average monthly salary of his Indian subjects. Along the same lines, Kachelmeier
and Shehata (1992) conduct their experiment in China, again offering real
payouts equal to three times the average monthly income of the subjects.
Siegel and Goldstein (1959) conducted a repeated experiment to test the impact
of payouts on the reliability of their results. They asked subjects to predict which
of two light bulbs would be turned on in several rounds and concluded, much
like many psychological studies, that subjects consistently violated rationality
assumptions of probability matching. Then, they offered a reward for correct
guesses and report that 90% of responses were correct.
On the other hand, Kahneman and Tversky (1979, pg. 265) scrutinize the use of
real payouts in their reference to experimental studies by stating that:
63
“Experimental studies typically involve contrived gambles for small

stakes, and a large number of repetitions of very similar problems.
These features of laboratory gambling complicate the
interpretation of the results and restrict their generality. By default,
the method of hypothetical choices emerges as the simplest
procedure by which a large number of theoretical questions can be
investigated. The use of the method relies on the assumption that
people often know how they would behave in actual situations of
choice, and on the further assumption that the subjects have no
special reason to disguise their true preferences.”
However, some years later Tversky and Kahneman (1986) bring forth an
alternative argument and show that the cognitive effort that subjects commit
when payouts are real substantially reduces anomalies, an assumption shared by
Smith and Walker (1993). Similar assumptions are made by Slovic and Tversky
(1974) who conclude that the better subjects understand the task and the more
attention they commit to it, the more they comply with normative predictions.
Takemura (1994), Sieck and Yates (1997) and Kuvaas and Selart (2004) provide
further evidence to that effect, and argue that thorough consideration of the
tasks reduce the framing effect that distorts the consistency of preferences. In
another study, Tversky and Kahneman (1992) also report no difference in their
findings with real and hypothetical payouts, and the same is concluded in Smith
and Walker (1993) in terms of mean bidding prices in auctions, although they do
note greater noise when payouts are hypothetical. This is also the conclusion of
Camerer and Hogarth (1999) who note that the only difference between data
extracted using real vs hypothetical payouts is that real payouts produce lower
data variability. Other evidence that confirms no differences in direct
comparisons of gambles with real and hypothetical payouts can be found in
Beattie and Loomes (1997) and Camerer (1995). Hertwig and Ortmann (2001)
provide elaborate reviews of relevant studies.
There is, however, also evidence of real payouts producing higher risk aversion,
as shown in Holt and Laury (2002), Kachelmeier and Shehata (1992) and Weber
et al. (2004). Camerer (1989) and Camerer and Hogarth (1999) attribute
reported levels of risk aversion for real payouts to experimental design. Other
research studies provide more significant differences. For example, Edwards
64
(1953) reports an increase in willingness to accept risk when subjects gambled

with real money, while Slovic (1969) reports that subjects revealed different
strategies when faced with real and hypothetical payouts.
Perhaps the most profound evidence of difference between real and hypothetical
payouts is produced through research experiments on the phenomenon of
preference reversals. Lichtenstein and Slovic (1971) used real payouts in an
experiment on preference reversals, which arguably increased the reliability of
their collected data set. Grether and Plott (1979) and Reilly (1982) also used real
payouts, albeit of very low amounts. The insignificance of the amounts was noted
by Pommerehne et al. (1982) who replicated the Grether and Plott experiment
using 100x larger payouts. Their results still report fewer, but evident,
preference reversals. The experiment of Harrison (1994) reports that preference
reversals disappear when real payouts are offered. Kuhberger et al (2002) argue
that research on preference reversals is inconclusive regarding the impact of real
vs hypothetical payouts.
Levin et al. (1988) examine framing effects and compare real and hypothetical
gambles with various levels of payouts ranging from $0.15-$2 in real payout
prospects, going up to $200 in hypothetical payouts. They report a lower impact
of the framing effect in real payout gambles. A similar technique of comparing
low and high, real and hypothetical payouts was applied in Hogarth and Einhorn
(1990), but real payouts were low and hypothetical payouts were large, so not
directly comparable.
To our knowledge, Kuhberger et al (2002) were correct to conclude that “there

are no studies that contrast real and hypothetical outcomes with nontrivial real
payouts. High payouts have only been used for hypothetical decisions.” There
are, however, some efforts to offer partly real payouts, i.e. payouts that are
contingent upon the number of participants or trials. Examples are found
Battalio et al. (1990), Grether and Cox (1996) and Slovic (1969).
Another payout-related indication of reference dependence is the interaction of

payouts and risk appetite. With regard to ranking tasks, the most common
approach is amount scaling, where subjects are presented prospects with
65
payouts of various magnitudes and their preferences are recorded. Implied risk
aversion has been found to increase as payouts increase. For example, in one of
the most widely cited experimental works on the subject of preferences between
monetary prospects, Hans Binswanger (1980; 1981) shows that when payouts
are low, 50% of decision makers displayed moderate risk-aversion, less than
10% displayed strong risk aversion and some 30% were risk-neutral or risk-
seeking. As payouts rose, 80% of the subjects displayed moderate risk-aversion,
and the risk-neutral and risk-seeking behaviours nearly vanished, in line with
Arrow’s assumption of decreasing absolute risk aversion. The conclusion that
risk aversion increases as payouts increase is also found in Holt and Laury
(2002), Smith and Walker (1993), Lefebvre et al. (2010) and Kachelmeier and
Shehata (1992).
In the context of contingent valuation, subjects specify bid (WTP) and ask (WTA)
prices for the underlying prospects. Mispricing of either task is assumed to be
related to risk aversion, although other reasons have been cited. In auction
settings, Harrison (1989) identifies overbidding but with relatively limited
consequences, and he notes that it is not necessarily driven by risk aversion and
could be the result of noise. Smith and Walker (1993) scale payout amounts 5x,
10x and 20x, but record no evidence of significance increases in overbidding.
Holt and Laury’s (2002) experiment mentioned earlier uses auction techniques
to examine the impact of payout levels on risk appetite, as well as to examine the
impact of real vs hypothetical payouts. They conduct an experiment with both
high and low payouts, where the high payouts are 20x, 50x and 90x the low
payouts. The payouts are presented in the table below.
66
Table 4.1: Holt and Laury’s Low Payout Pairs
Option A Option B Expected

Payoff
Payoff Probability Payoff Probability Payoff Probability Payoff Probability Difference
$2,00 10% $1,60 90,00% $3,85 10% $0,10 90,00% $1,17
$2,00 20% $1,60 80,00% $3,85 20% $0,10 80,00% $0,83
$2,00 30% $1,60 70,00% $3,85 30% $0,10 70,00% $0,50
$2,00 40% $1,60 60,00% $3,85 40% $0,10 60,00% $0,16
$2,00 50% $1,60 50,00% $3,85 50% $0,10 50,00% -$0,18
$2,00 60% $1,60 40,00% $3,85 60% $0,10 40,00% -$0,51
$2,00 70% $1,60 30,00% $3,85 70% $0,10 30,00% -$0,85
$2,00 80% $1,60 20,00% $3,85 80% $0,10 20,00% -$1,18
$2,00 90% $1,60 10,00% $3,85 90% $0,10 10,00% -$1,52
$2,00 100% $1,60 0,00% $3,85 100% $0,10 0,00% -$1,85
Source: Holt and Laury (2002)
The experiment is designed to test both risk aversion with regard to the level of
the payouts and the significance of real and hypothetical payouts. In terms of risk
aversion, they find that risk aversion increases as payouts increase. The
technique they use is to scale the amounts of by a constant , and observe the
crossover point at which subjects switch from the low risk option to the high risk
option. The crossover point in terms of expected payout marks the expected
crossover point for the risk neutral decision maker – it is the point where the
difference becomes negative.
They show that the majority of the subjects chose the safe option when the
probability of the high payout was small, then crossed over to the risky prospect.
Moreover, as payouts increased, risk aversion increased (inconsistent with
constant relative risk aversion when utility is a function of income and not
wealth). Finally, in hypothetical payout choices, they found no significant
difference in attitude, except that some subjects switched over after an initial
cross-over.
Holt and Laury (2002, pg. 1644) note that
“Independent of the method used to elicit a measure of risk

aversion, there is widespread belief… that the degree of risk
aversion needed to explain behaviour in low-payout settings would
imply absurd levels of risk aversion in high-payout settings”.
Read (2005) is critical of Holt and Laury’s experimental design, on the premises
that subjects were repeatedly told that some choices were real and that others
67
were hypothetical, thereby confusing and/or influencing their decision making.

Along the same lines, Plott and Zeiler (2005) note that experiments using the
BDM method do tend to be complicated and cognitively challenging for some
subjects. Wilcox (1993; 2008) reports that the “random lottery mechanism”
procedure often leads to results that are controversial with both real and
hypothetical payouts, a finding reported also in Beattie and Loomes (1997) and
in Kuhberger et al. (2002).
Moreover, Grether and Plott (1979) provide one of the most prolific and rigid
critiques of the experimental findings on choice. Their emphasis is on preference
reversals, but with insightful extensions to experimental methodologies overall.
They argue that real, known outcomes are the only reliable incentive that should
be provided for the extraction of revealed preference. They also warn that
context effects and biases are often artificially created in laboratory experiments,
inducing strategic behaviour that leads to misleading results.
As experimental evidence on preference compiles along with theoretical

attempts to explain violations in expected utility, several concepts, typical to
most relevant experiments, remain problematic. Indeed experimental studies of
risky prospects share the following controversial practices:
1. Most experiments are carried out in laboratory settings with students as

respondents (Harrison and List, 2004). The author is not aware of any study
on risky preferences using data drawn from investor groups, which feature
financial literacy and familiarity with the concepts of probability and return.
2. In some studies payout amounts be hypothetical, in others they are very

small or very high. To the best of my knowledge there are only two relevant
studies31 where actual payouts bear subjective significance for the subjects,
albeit allowing for some cognitive biases as subjects lacked financial literacy.
3. Probability levels are often very low or very high, allowing for biases to
prevail (Kahneman and Tversky, 1979; 1992). A small number of studies
31 Reference to Binswanger (1980; 1981) and Kachelmeier and Shehata (1992)
68
combine various probability levels with actual and subjectively significant

payouts, where prospects are directly comparable.
4. Pricing tasks are based on equivalent valuations for each risky prospect.
While the vast majority of relevant studies contains sets of certainty
equivalent tasks, these tasks are usually carried out with little consideration
to potential distortions such as framing. Many studies identify framing effects
but no effective controls are applied in contingent valuation.
4.3 Experimental Evidence on Risk Preference
In this section I present some key behavioural observations regarding revealed

risk preferences. I shall not make extensive reference to relevant observations
regarding ambiguous prospects, as the formulation of beliefs is beyond the scope
of this thesis32.
4.3.1 Introduction to Reference Dependence
Whether due to computational failure or idiosyncratic anomalies, risky choice

does not always follow rationality predictions. Reference dependence is
commonly reported in a variety of experiments and contexts and some
anomalies linked to it are discussed in this section.
In terms of probability assessment, Kahneman and Riepe (1998) provide the

following example of asymmetric perception, indicating reference dependent
probabilities:
“You are facing a chance for a gain of €20,000. You do not know the exact
probability. Consider the three pairs of outcomes:
A. The probability is either 0 or 1%

B. The probability is either 41% or 42%
C. The probability is either 99% or 100%
32A brief reference to some related findings with regard to investor beliefs is presented in
Appendix A.
69
Are the three differences, A, B and C, equally significant to a decision maker?

Could you order them by their impact on preferences?”
Rational choice presumes that all three probability pairs carry the same weight.
Essentially, a 1% difference in probability should have the same effect on the
weighting of the prospect regardless of which probability pair is being
considered. In practice, however, experimental evidence proves that decision
makers overweight low probabilities and underweight high probabilities, in
violation of EUT and rationality assumptions. Kahneman and Riepe argue that
this is why people find a 1% chance to win €1,000 more attractive than a €10
gift.
Furthermore, amount-related reference dependence is persuasively exhibited in

terms of loss aversion. Samuelson (1963) was one of the first researchers to
illustrate loss aversion with an example: a colleague would not participate in a
gamble offering an even chance to a $200 win and a $100 loss. The same
colleague stated he would accept a string of 100such bets. As Samuelson notes,
this sort of behaviour exhibits an irrational application of the law of averages to a
sum, leading to the popular perception that the rejection of a single favourable
bet and acceptance of a sequence of favourable bets is a “fallacy of large
numbers” (Pekoz, 2002). The same attitude is recorded in Redelmeier and
Tversky (1992) who present a similar problem with a tenfold higher gain and a
fivefold higher loss, and still report that only 43% of the subjects were willing to
play the gamble. Kahneman and Tversky (1979), Wedell and Bockenholt (1994)
and Tom et al. (2007) test preferences in similar experimental tasks and draw
the same results of loss aversion.
Although one might find numerous exhibitions of loss aversion in the literature,
to our knowledge there have been very few reports that include a side-by-side
comparison of attitudes towards large and small stakes, pointing to the
importance of the subjective significance of amounts. Perhaps more importantly,
I found no evidence of comparison between the risky prospects with the level of
payouts discussed above and risky prospects featuring payouts 10 or 100 times
higher.
70
4.3.2 Framing and Context Effects
The EU principle of invariance assumes procedure invariance, which implies that

response modes and the framing of the decision problem should not affect the
preference order. Substantial objections have been documented on that
assumption (for example in Tversky and Kahneman, 1986; Tversky, Sattath and
Slovic, 1988), also called extensionality (Arrow, 1982).
An underlining exhibition of the reference dependence assumption is the

cognitive bias of framing. Preferences that were traditionally assumed to be
invariant towards the framing of the decision problem revert when decision
problems are reframed. In practice, as a result, the invariance assumption must
be relaxed. Kahneman (2003) provides an elaborate description of framing and
context effects. He detects framing where “extensionally equivalent decisions
lead to different choices by altering the relative salience of different aspects of
the problem”. He notes that framing effects are caused by a “passive acceptance”
of the presentation of the decision problem which violates invariance causing a
preference reversal. In other words, the framing of decision problems render
some features highly accessible while other features that are less obvious are
ignored. The resulting choices often divert from predicted rational choice.
Kahneman offers a theory on framing, arguing that it occurs when people decide
intuitively, rather than after careful consideration of the prospects at hand.
Framing is exemplified in Tversky and Kahneman (1981) who show how

invariance using the following example:
Assuming we are expecting the outbreak of a disease in the US which is

expected to kill 600 people, two therapeutic options are available to choose
from:
If Option A is adopted, 200 people will be saved
If Option B is adopted, there is one-third probability that 600 people will be

saved and two-thirds probability that no people will be saved.
71
In this version of the decision problem, the majority of the respondents chose
Option A. Another set of respondents is presented with the same decision
problem, with the same options A and B, but presented in the following manner:
If Option A’ is adopted, 400 people will die.
If Option B’ is adopted, there is a one-third probability that nobody will

die and a two-thirds probability that 600 people will die.
The majority of the respondents chose Option B’.
Options A and A’ both offer a certain outcome, while options B and B’ both
contain uncertainty. The very high stakes in this decision problem, i.e. life and
death, are “disproportionately attractive and aversive” (Kahneman, 2003)
leading to a distortion of the attractiveness of the life-preserving scenario and of
the death-forecasting scenario. This evidence indicates that contrary to
traditional economic theory, which assumes broad bracketing by maximizing
total utility functions, economic agents often assess their prospects in isolation,
and not in reference to their wider wealth levels, their aggregate long-term
wealth or their total risk exposure.
An extension of the framing effect is “narrow framing”, a term introduced in

Kahneman and Lovallo (1993) based on the findings of Tversky and Kahneman
(1981). Barberis et al. (2006) define narrow framing as follows:
“In traditional models, which define utility over total wealth or

consumption, an agent who is offered a new gamble evaluates that
gamble by merging it with other risks she already faces and
checking whether the combination is attractive. Narrow framing,
by contrast, occurs when an agent who is offered a new gamble
evaluates that gamble to some extent in isolation, separately from
her other risks”.
Narrow framing is also known as “mental accounting” (Thaler, 1985; 1999),

“decision bracketing” and “choice bracketing” (Read et al, 1999), “outcome
editing” (Kahneman and Tversky, 1979; Thaler, 1985), all terms referring to the
assumption that prospects are often evaluated in isolation, in different “mental
boxes”.
72
Evidence on narrow framing is provided in Kahneman and Tversky (1979),

through the following choice task:
Choice Problem 1:
In addition to whatever you own, you are given €20,000 and asked to choose
between the following two options:
A. Receive €5,000, or
B. 50% chance to win €10,000, else win nothing
Choice Problem 2:
In addition to whatever you own, you are given €30,000 and asked to choose
between the following two options:
C. Lose €5,000 or
D. 50% chance to lose €10,000, else lose nothing.
The characteristic of this choice problem is that it contains two options that are
are essentially identical, because in EU terms they produce the same final wealth,
and the two decision problems offer the same probabilities for the same net
payouts. The majority of subjects choose A in CP1, and D in CP2, effectively
revealing inconsistent preferences. Framing leading to preference reversals of
this sort points to the assumption that the decision problem is presented as a
decision between gains and losses, rather than in final states of wealth. This
exemplification of computational limitation or misunderstanding can become a
valuable tool for the isolation of framing effects from the analysis of financial
decisions.
Tversky and Kahneman (1981) present one more striking example of mental
accounting and reference dependence, repeated below. Subjects were presented
with the following two versions of the same decision problem:
Version A
Suppose you intend to buy a jacket for $125 and a calculator for $15 and
the salesman informs you that the calculator is on sale for $10 at another
73
branch of the store some 20 minute drive away. Would you take the trip
to the other store?
Version B
Suppose you intend to buy a jacket for $15 and a calculator for $125 and
the salesman informs you that the calculator is on sale for $120 at another
branch of the store some 20 minute drive away. Would you take the trip
to the other store?
The majority of subjects answer that they would travel to save the $5 in version
A, but not in version B.
Let W = existing wealth, J = Purchased Jacket, C = Purchased Calculator. After the

purchase of the two items, in both versions is:
If the subject chooses to take the 20 minute drive T and save $5, then:
If the subject chooses not to take the 20 minute drive T, then:
As subjects choose to take the trip in version A and to not take the trip in version
B, a violation of the completeness axiom is observed.
Kahneman and Tversky (1984), inspired by similar examples by Savage (1954)

and Thaler (1980) provide the following example of mental accounting. Subjects
are asked, among others, the following question:
- Would you accept a gamble that offers a 10% chance to

win $95 and a 90% chance to lose $5?
Several questions later, they were asked 33 the following:
33In the original experiment, the questions were also reversed in terms of order for half of the
subjects, to avoid ordering effects.
74
- Would you pay $5 to participate in a lottery that offers a

10% chance to win $100 and a 90% chance to win
nothing?
The two decision problems are essentially identical. However, 55 out of 132
respondents expressed different preferences in the two questions. In fact, 42
subjects rejected the mixed gamble which featured losses and accepted the
framed gamble of the second question. Kahneman and Tversky (1984) conclude
that subjects frame negative outcomes as costs rather than losses. In fact, this is
precisely the premises on which the Sequential Equivalence methodology
introduced in this thesis is based, as discussed later on.
Additional evidence of narrow framing are available in Keren and Wagenaar

(1987), Tversky and Simonson (1993), Redelmeier and Tversky (1992),
Herrnstein and Prelec (1992a, 1992b), Kahneman and Lovallo (1993), Rachlin
(1995), Heyman (1996), Benarzi and Thaler (1999), and in Hsee et al (1999). In
all of the above studies evidence points to the conclusion that the decision of
participating or rejecting a lottery is evaluated as a self-contained opportunity.
With respect to investment decisions, Barberis and Huang (2001) show that
investor decisions about individual products are often considered in isolation
from the investor portfolio.
Finally, Barberis et al. (2006) use a common observation to show that although
loss aversion can partially explain this preference ordering, the assumption of
narrow framing is required to fully represent the rejection of favourable gambles
like Rabin’s (2000) presented earlier. They retain the assumption that utility is
extracted from changes in wealth, and propose loss aversion as the solution to
the problem. The use of narrow framing allows the separation of the relevant
risky prospect from other wealth-related risks. A broadly framed decision
process as described in EUT can still not explain foregoing the opportunity to
participate in L.
75
4.3.3 The Endowment Effect
The endowment effect is a combination of reference dependence and loss

aversion, and one of the most profound manifestations of framing and mental
accounting. The term is attributed to Thaler (1980) who identified a pattern that
people often demand more to give up an item in their possession than they are
willing to give up to acquire it. It is the same as the concept Samuelson and
Zeckhauser’s (1988) call the “status quo bias”, the tendency to try to remain at
one’s current state. The most widely cited experiments on the endowment effect
come from Kahneman, Knetsch and Thaler (1990) and to illustrate I shall use a
simplified example of one of their experiments: They handed half of the students
in their sample a mug and asked all subjects to trade. The reference point of the
mug owners includes the ownership of the mug. The reference point of non-
owners includes the ownership of zero mugs. As a result, the sale of the mug on
behalf of the mug owners entails the loss of the mug, while buying the mug is a
gain for the non-owners. Given the principle of loss aversion, the buyers of the
mug place a lower price tag on the mug.
The endowment effect is generally documented in the observed disparity

between the price decision makers are willing to pay (WTP) to purchase an item
and the price decision makers are willing to accept (WTA) to sell the same item.
As discussed, the disparity between WTA and WTP is acceptable up to a certain
degree and under specific assumptions. However, a large disparity that
neoclassical theory cannot accommodate between economic agents’ buying price
(or WTP) and their selling price (or WTA) was first explicitly stated in Hammack
and Brown (1974). Their experiment on the contingent valuation of
environmental amenities produced evidence of a profound WTA/WTP disparity.
They examined the price hunters were willing to pay to prevent the destruction
of a hunting site, and the amount that hunters would accept as compensation for
the loss of the site. Their WTP was on average $247, and their WTA was $1,044.
The essential information contained in the WTP value is an approximation of the

certainty equivalent of a prospect, i.e. the certain payout that is a perfect
substitute for the risk assumed through the uncertain prospect. Contrary to
Willig’s (1976) normative conclusion that WTP and WTA prices should be the
76
same, more often than not people’s WTA prices are substantially higher than
their WTP prices for the same prospect. Numerous experiments show that
consumers tend to state higher prices when asked to sell an item in their
possession than when asked what they are willing to pay to purchase that item
(Coombs et al., 1967; Slovic and Lichtenstein, 1968; Knetsch and Borcherding,
1979; Thaler, 1980; Knetsch and Sinden, 1984; Knetsch, 1984; Kahneman et al.,
1991; Hoffman and Spitzer, 1993; Loewenstein and Adler, 1995; Pratt and
Zeckhauser, 1996; Curran, 2000).
One explanation for the observed large WTA-WTP disparity is provided in

Hannemann (1991) who argues that it is the result of low elasticity of
substitution between income and the underlying prospects. Furthermore,
Shogren et al (1994) compare the disparity in valuations for market and
nonmarket goods and show that experience dissolves the WTA/WTP disparity in
nonmarket goods while the market goods’ disparity persisted. Given the fact that
elasticities of substitution of nonmarket goods are smaller than for market
goods, they conclude that the disparity is due to the substitution effect. Bateman
et al. (1997) argue that this is an arbitrary and speculative interpretation.
Further studies by Knetsch and Sinden (1984) and Knetsch (1989) controlled for
income and substitution effects and find a prevailing disparity contrary to
neoclassical preference theory.
The prevailing theoretical explanation for the discrepancy between WTP and
WTA prices is the endowment effect (Thaler, 1980) and - by extension - loss
aversion (Knetsch et al., 2001), where reference-dependent preferences lead to
an overstated treatment of losses. Kahneman et al. (1990) review a series of
experiments and conclude that people avert losses and require a premium to
part with items in their ownership. Horowitz and McConnell (2002) review 45
studies on the endowment effect, and report similar findings. Some key
observations from both surveys are presented in the table below.
77
Table 4.2: WTA vs WTP disparity surveys
Hypothetical "H" vs Real "R" Means Medians

Study
Entitlement WTP WTA Ratio WTP WTA Ratio
Hammack & Brown (1974) H / Marshes $247 $1,044 4.2
Sinclair (1978) H / Fishing 35 100 2.9
Banford et al (1979) H / Fishing Pier 43 120 2.8 47 129 2.7
Banford et al (1979) H / Post 22 93 4.2 22 106 4.8
Bishop & Heberlein (1979) H / Goose Hunting Permits 21 101 4.8
Rowe et al (1980) H / Visibility 1.33 3.49 2.6
Brookshire et al (1980) H / Elk Hunting 54 143 2.6
Haberlein & Bishop (1985) H / Deer Hunting 31 513 16.5
Knetsch & Sinden (1984) R / Lottery Tickets 1.28 5.18 4
Heberlein & Bishop (1985) R/ Deer Hunting 25 172 6.9
Coursey et al (1987) R / Taste of Sucrose 3.45 4.71 1.4 1.33 3.49 2.6
Brookshire & Coursey (1987) R / Park Trees 10.12 56.60 5.6 6.30 12.96 2.1
Source: Kahneman et al. (1990)
Hypothetical "H" vs Real "R" / Median WTA / Mean WTA /

Study Mean WTP
Entitlement Median WTP Mean WTP
Adamowitcz et al (1993) H / Hockey Ticket w Substitute 1.85 1.70 $28.50

Adamowitcz et al (1993) H / Hockey Ticket w/o Substitute 1.87 1.91 $36.60
Banford, Knetsch & Mauser (1979; 1980) H / Ocean Pier 2.60 2.78 $43.10
Banford, Knetsch & Mauser (1979; 1980) H / Post 4.40 4.24 $21.97
Bateman et al (1997) R / Chocolates 2 2.09 8.7 chocs
Bateman et al (1997) R / Money GBP2.00 3.95 2.81 GBP0.78
Bateman et al (1997) R / Refreshment 2 2 2.5 cans
Bateman et al (1997) R / Money GBP0.80 1.30 2.53 GBP0.60
Eisenberger & Weber (1995) R / Lottery - 1.44 DM4.23
Horowitz (1991) R / $50 in 1 month 1.60 2.44 $30.64
Kachelmeirer & Shehata (1992) R / Lottery 1.67 1.83 $6.07
Kachelmeirer & Shehata (1992) R / Lottery 2 2.07 $5.12
Source: Horowitz and McConnell (2002)
The WTA/WTP disparity has also been emphasized in Thaler (1980), Knetsch
and Sinden (1984; 1987), Brookshire and Coursey (1987), Knetsch (1989),
Kahneman et al (1990; 1991), Thaler et al. (1992), Borges and Knetsch (1998),
Shogren et al (2001), Slovic and Lichtenstein (2006), and Traub and Schmidt
(2009). In fact the phenomenon has been recorded in decisions involving a wide
variety of underlying payouts, for example in decision problems regarding safety
and accident risk (Mc Daniels, 1992; Duborg et al., 1994; Samuelson and
Zeckhauser, 1988), power supply (Hartman et al., 1990) and health risks
(Shogren et al., 1994). Coursey et al. (1987) argue that under certainty, WTP is a
better measure than WTA because WTP remains constant, while WTA tends to
decrease with experience. Thaler (1980) examines behaviour with very
significant stakes of life and death and in his famous paper on narrow framing
reports that the WTA of people asked to assume a 0.001 risk of death was 100%-
200% times higher than the maximum amount they were willing to pay to avoid
that same risk of death.
78
Specifically for lottery choice, a comprehensive comparison of mean WTA vs

WTP values is available in Traub (1999) and in Horowitz and McConnell (2002)
who report a 2.10 mean WTA/WTP ratio for lottery pricing tasks. Knetsch and
Sinden (1984) also report a median WTA/WTP exceeding two. Harless (1989)
and Eisenberger and Weber (1995) report a median WTA-WTP ratio close to
one. In fact the latter used the BDM method to obtain buying, selling, short-
selling and short-buying prices and conclude that subjects distinguish between
risk and ambiguity when faced with lotteries. In the context of lottery decision-
making, Kachelmeier and Shehata (1992) provide evidence of the endowment
effect and conclude it is the primary source of the WTA/WTP disparity.
Knetsch et al. (2001, pg. 257) start their interesting review of vickrey valuations
with the following statement:
“The endowment effect and loss aversion have been one of the
most robust findings of the psychology of decision making. People
commonly value losses much more than commensurate gains”.
They then conduct an interesting experiment with repeated Vickrey auctions,

and they report that the endowment effect persists. This persistence is sustained,
although they show that Vickrey auction mechanisms are susceptible to context
effects.
The plethora of empirical evidence documenting the presence of a WTA/WTP

disparity is met with prolific research on the drivers that cause the phenomenon
as well as controls that might be applied to reduce it. List (2003) examines the
endowment effect in terms of endurance and persistence and argues that it
reduces with experience. This finding is significant, as it adds a cognitive and
skill-related dimension to the WTA/WTP disparity. Samuelson and Zeckhauser
(1988) argue that the WTA/WTP gap is a result of the status-quo bias, which
states that decision makers dislike changes in their current state, implying a
reference-dependence. Shahrabani et al (2007) reach the same conclusion and
attribute their reported analysis on stock market short-selling WTA prices to the
status-quo bias, using a Vickrey auction. Harless (1989) also argues that second-
price sealed-bid auctions provide more efficient approximations of WTA and
WTP values, reducing the disparity. The counterargument of Loomes et al (2003)
79
is that the reduced disparity is due to the setup of the experiment rather than the
avoidance of biases and heuristics. Hanneman (1991) argues that the WTA/WTP
disparity in public goods is due to the income and substitution effects, and that
experimental results are greatly affected by misperceptions of subjects. Plott and
Zeiler (2005) also show that subject misconceptions are partly to blame for the
WTA/WTP gap. The experimental procedures applied in the extraction of
revealed preference is indeed key, and it is surprising that much primary data is
being considered with little or no consideration of the experimental framework
that may have driven it.
On the other hand, a number of reports have confirmed the enduring presence of
the endowment effect in settings adjusted for relevant effects: Bateman et al.
(1997) and Morrison (1997) controlled for income effects upon extraction of
WTA and WTP values and still recorded a significant endowment effect. The
same results supporting the endowment effect are noted in literature even in
experimental settings involving real payouts and realistic settings.
4.3.4 Preference Reversals
Preference and choice are words often used interchangeably as they are
considered to point in the same decision. Observations, however, also report
cases where subjects state a preference for one option, and then choose another
(Tversky and Thaler (1990); Tversky et al, 1990; Slovic and Lichtenstein, 2006).
By definition, a decision maker who prefers prospect A over prospect B, should
be willing to pay more for A and less for B. A stated preference for A and a stated
higher price for B in decision theory is a preference reversal, exemplified below.
Suppose the decision maker is faced with the following two lotteries:
A: 15% chance to win €10,000, else win nothing

B: 90% chance to win €1,650, else win nothing
and asked to a) rank them by order of attractiveness (state a preference), and b)

state the minimum price at which he is willing to sell these lotteries (cash
equivalent). The decision maker shall state a preference , , or both,
80
and assign the values and to each lottery respectively. For these two
values 34, or .
If , then by transitivity . If , then by transitivity ,

and if A ≈ B, then .
If the decision maker states a preference for A and then assigns a higher value to
B, the preference reversal marks a violation of transitivity. A related concept is
that of procedure invariance discussed earlier, which essentially assumes that
procedural modifications do not result in different results. By extension, this
condition postulates that when a decision maker prefers the risky prospect to a
cash amount, then the selling price he will assign to the risky prospect should
exceed that cash amount. In the above example, procedure invariance postulates
that for any amount , if , then , and if , then B ≈ X.
Pioneering work on preference reversals is attributed to Slovic and Lichtenstein

(1968), Lichtenstein and Slovic (1971; 1973) and Lindman (1971). Their
experiments were set up using lotteries with similar EVs and asked subjects to
choose between two prospects, one offering a high chance of winning a small
amount, and one offering a low chance of winning a high amount. They labelled
these payout/probability pairs the and the respectively35.
Preference reversal is observed when subjects chose the but assign a
higher value to the when asked to sell the prospects. Moreover, the type
of preference reversal that occurs between buying and selling prices (eg.
Birnbaum and Sutton, 1992) points to the endowment effect. Extensive research
work on the subject in the 1980s36 concluded that preference reversals can be
attributed to anchoring on either the probability or the payout, creating an
asymmetry between the evaluation procedure and the choice procedure that
decision makers follow.
Similar reversals have also been recorded in ratings of attractiveness (Goldstein

and Einhorn, 1987); in ratings of purchase likelihood (Nowlis and Simonson,
34 Assuming that more money is preferred to less money.

35 Also referred to as H bet and L bet (Tversky et al., in Lichtenstein and Slovic, 2006)
36 See Hamm (1984), Pommerehne et al. (1982), Reilly (1982), Mowen and Gentry (1980), Berg
et al. (2003)
81
1994; 1997; 2000); in decisions among consumer products such as ice cream
(Hsee, 1998) and TVs (Nowlis and Simonson, 1997); in decisions of job seekers
(Tversky et al., 1988; Hsee, 1996); and in job offers (Hsee et al., 1991; Hsee et al.,
1999). Preference reversals also occur in decisions for payouts expected in two
different points in time (Lichtenstein and Slovic, 2006). Finally, preference
reversals have been documented in choices when losses are introduced or
increased (Goldstein and Einhorn, 1987; Lichtenstein and Slovic, 2006)37.
The theoretical impact of preference reversals is a profound violation of

transitivity, procedure invariance or the independence axiom. Non-transitive
choice models were proposed by Fishburn (1985) who relaxed the transitivity
assumption and argued that such inconsistencies are due to regret, in line with
earlier work of Loomes and Sudgen (1982; 1983) on regret theory. Tversky at al.
(1988) and Goldestein and Einhorn (1987) propose “response bias” models as
theoretical adaptations to violations of procedural invariance. Furthermore,
generalized utility models with transitivity but without the independence axiom
were proposed by Holt (1986), Karni and Safra (1987) and Segal (1988).
According to Tversky et al. (1990) these generalized utility models failed to
produce any persuasive explanation for preference reversals. With the exception
of Loomes and Sudgen’s (1982) regret-utility hypothesis, all of the above models
suggest that preference reversals occur when the subjects’ revealed indifference
point is different from the indifference point implied by the lottery.
In terms of experimental techniques regarding preference reversals, Grether and

Plott (1979) present a list of criticisms on the empirical procedure and the
theoretical value of empirical findings on preference reversals. They note that
“this inconsistency is deeper than the mere lack of transitivity or even stochastic
transitivity. It suggests that no optimization principles of any sort lie behind even
the simplest of human choices” (Grether & Plott, 1979, pg. 623). Their main
objections were poor motivation for accuracy and truthfulness among subjects,
as well as income effects.
37A full review of research dealing with possible explanations for the preference reversal
phenomenon is available in Seidl (2002)
82
With framing effects playing a leading role in any statement of preference, and
given the descriptive failures of procedural invariance, it is surprising that
preference reversals have not been examined as a result of the significance of the
outcomes. Preference reversals may be based on biases, heuristics,
miscalculations or indifference.
As a final note, apparently most research on preference reversals deals with very
insignificant or insignificant amounts by Western European standards, even
when payouts are hypothetical. As the impact of the subjective significance of the
payouts remains to the best of our knowledge under-researched, this thesis
addresses the role of the subjective significance of amounts in more detail.
83
Chapter 5 - Methodology
This research in its entirety deals with preferences and the way people choose
between risky prospects. In other words, the analysis focuses on the way
decision makers choose between prospects whose probabilities and payouts are
explicitly stated. The applied methodology comprises an empirical and a
theoretical component. In its entirety, the analysis is based on empirical
evidence. To that effect, this analysis shall:
1. Test for interaction of risk appetite and the level of the risky payouts,
2. Test for evidence of an endowment effect,
3. Test for asymmetries in the significance of amounts in the gains’ and
losses’ domains.
Using an innovative experimental design I introduce a methodology for efficient

contingent valuation, which minimizes the WTA/WTP disparity and any
endowment effects. This method reveals any asymmetry in the significance of
amounts and highlights its impact on risk appetite in the context of reference-
dependence. Finally, a loss-adjusted estimate for risk aversion to incorporate
loss aversion effects is considered.
5.1 Methodological Approach
This study uses primary data collected through a questionnaire designed to

reveal preferences among risky prospects. The decision tasks employed are
simple binary lotteries with monetary outcomes. All lotteries have positive
expected values38. The aim is to determine the main drivers of choice between
risky prospects, and to examine any variations of these drivers in terms of
reference-dependence. Towards that goal, the impact of any wealth effects,
framing effects and the endowment effect is analysed.
38 Unless excessive bidding occurs, which is possible in one section of the questionnaire.
84
Chapter 5 Methodology
As discussed in the previous chapter, the importance of payout amounts in

providing incentive for thoughtful and truthful response is often compromised
and payout amounts are often unrealistically large or insignificantly small,
leading to distortion of revealed preferences. In addition, subjects are usually
drawn out of a pool of students or various sets of professionals, albeit usually
low income and sophistication as in Binswanger (1980; 1981). The problem with
student samples is that they are constrained by low income levels, limited or no
investment experience and at best a theoretical understanding of probability.
The problem with drawing samples from groups of professionals with limited or
no financial literacy is the prevailing impact of miscalculation, misunderstanding
and the limitation of questions to simple tasks. To address these issues, the
experiment described in this thesis uses a mix of real and hypothetical payout
lotteries, on a sample of active professional or individual investors. The
methodology combines findings on the following three categories to decompose
the preference ordering of subjects:
a) The Significance of Amounts: Although extensive research has examined the

impact of probability distributions on preferences, a surprisingly limited
amount of work is allocated to the relevant impact of payouts. In the absence
of prospective losses, decision maker choices exhibit increasing risk aversion
as payouts rise, and decreasing risk aversion as payouts fall. This observation
is contingent upon each decision makers subjective significance of amounts.
b) Pricing inconsistencies and loss aversion: The application WTP and WTA
methods for the approximation of the certainty equivalents of risky prospects
results in the revelation that subjects consistently underestimate their
propensity to risk. This observation, i.e. the underestimated propensity to
risk, contributes to the WTP/WTA disparity widely discussed in prior
literature. The disparity can be reduced with a corrected, sequential
experimental method for the extraction of WTP prices. By extension, the
correction bears great theoretical significance in terms of loss aversion and
the endowment effect which, when faced with monetary payouts, is
significantly reduced. It also highlights the reference-dependent property of
the significance of amounts.
85
c) Experimental Techniques: This analysis of revealed risk aversion indicates

that there is ample room for improvisation as there is a plethora of
approaches we considered (and indeed applied in pilot rounds) prior to the
completion of the final questionnaire. In its final version, the questionnaire
comprises three rounds of questions, corresponding to three methods to
arrive at a reliable set of revealed and stated preferences.
i. Rankings: Bundles of binary lotteries featuring hypothetical payouts, all
with the same EV, at various significance levels;
ii. Contingent Valuation: Willingness to Pay (WTP) is extracted using an
initial bundle of 6 binary lotteries, with the same EV and a fixed
probability distribution, asking subjects to state their maximum bid price
for the purchase of the lottery ticket. This initial set offers real payouts to
the highest bidder. In sequential WTP (SWTP) subsequent bundles of
lotteries reduce both outcomes of the each lottery by the stated WTP
price, thereby transforming gains-only lotteries into mixed lotteries. The
procedure is repeated up to four times, or until the subject provided a
price of 0 or rejected the lottery.
iii. Contingent Valuation: Willingness to Accept (WTA) comprises bundles of
binary lotteries featuring the WTP set of gains-only lotteries and the set of
lotteries that are calculated using the SWTP method.
5.1.1 Managing Complexity
The decision making process is a complex procedure with strong subjective

variations that, I believe, cannot be universally, consistently, continuously and
efficiently understood, described or predicted. For investment decisions in
particular, the list of decision drivers is very long and the resulting inherent
complexity for the analysis of investor decisions is quite high. In order to contain
this complexity and reduce some “noise” in this analysis, I use two simplification
drivers in this research: a) preferences over lotteries are extracted, and b) the
payouts are restricted to strictly monetary gains and losses. The use of lotteries
serves as a driver towards the reduction of belief-related complexity. Some
aspects of the formulation of beliefs lie beyond the grasp of economics. This is
because it is a multidisciplinary task of great complexity; more difficult yet is to
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explain why and how beliefs vary. And indeed it is the very variability of beliefs
that moves markets, since, for example, if all investors believed a stock would
continue to rise indefinitely, it would lead to a no-sellers’ market with
theoretically inflated prices. The reason why stock prices rise and fall is precisely
because some investors buy the stock expecting it will rise, and some investors
sell the stock expecting it will fall. Stocks move because different investors have
different views about the future.
The reasons why an investor believes a stock will rise and in what time frame, as
well as how confident he is that his expectation shall materialize, is no doubt
both important and good to know. It is, however, not a prerequisite for the
understanding of investor preferences. The reason is that preferences are about
the combined assessment of payout and probability. While there is no way
around the analysis of the way people perceive any given prospect, there is a way
to work around the way people form expectations about the future state of the
things. This can be achieved by stating the probability of each outcome as a
given. With the use of explicitly determined probabilities, most of the belief-
related uncertainty is removed and this analysis can focus on preference
construction. The reduction of actual financial investments to lottery-like
investments is a belief-related simplification factor, which reduces uncertainty to
risk.
On the other hand, preference-related complexity stems from the decision

maker’s assessment of the outcomes’ attributes. With decisions involving
consumer goods, for example, a number of potentially correlated factors interact,
and preferences are based on the interaction of tastes, disposition, personal
circumstance, etc. Indeed a full understanding of these interactions can perhaps
not be fully comprehensive. To illustrate this point consider the following
example: when choosing between an orange and an apple, the definitive factor
for preference construction may be personal taste, the doctor’s orders, the resale
value of these items, etc. When choosing between [winning an orange with 50%
certainty, or win nothing] versus [winning an apple with 50% certainty, or win
nothing] again the definitive decision factors lie with the decision maker’s taste
for apples and oranges. Drawing from a very large pool of experiments published
87
in literature, Bateman et al. (1997) conduct an experiment on reference-

dependence and the WTA/WTP disparity and use cans of Coke and luxury
chocolates to elicit preferences. The preference for either good is directly related
to personal preferences and there is no way of controlling for the “taste” factor in
experiments of this sort. This problem was further acknowledged by Borger and
Fosgerau (2006) who conducted a similar experiment using trade-offs between
money and travel time. Again, the introduction travel time imposed a non-
quantifiable subjective dimension to the decision task, and any analysis cannot
entirely control for its impact.
This problem is significantly reduced by restricting the decision problem to

strictly monetary outcomes. By excluding consumer products from this research
all complexity stemming from personal tastes and other attribute preferences is
effortlessly excluded, and the focus shifts towards a “commodity” that is
desirable to the vast majority of decision makers: Cash. The underlining
assumption is that more money is preferred to less money, therefore by
extension decision makers are assumed to prefer the prospect that they expect
will maximize their wealth, by adding value to their current position. As a result,
all outcomes in the prospects analysed in this research are money payouts.
5.1.2 Sample Selection
Experimental evidence on risk aversion and the perception of risk are typically
drawn from questionnaires and other tests carried out in university classrooms.
The direct implication is a uniformity of the samples, which are not dispersed
across age, education, financial and marital status, etc. Moreover, while the
revealed preferences of these subjects during their 3 or 4 years as university
students are recorded, there is no way to predict, infer or assume what these
same subjects’ preferences will be as professionals, a role they shall assume for a
much longer period of time in their lifetime.
For this analysis some consideration was given regarding potentially choosing a
population representative sample, which would include a weighted number of
numerous representatives from several social groups. While such a group would
contain ample diversity, it would also yield questionable comparability of the
88
results. If subjects were entirely heterogeneous their net worth and in their
perception of probability, the isolated effects this analysis focuses on would be
shadowed by noise. In fact, at the design phase of the questionnaire, various tests
and pilot rounds were conducted to examine the response accuracy and ability to
follow the required thought path across several groups, ranging from UK-based
hairdressers to economics professors in Switzerland. The target audience chosen
for this analysis is a convenience group of active business and finance
professionals that is financially literate, over 25 and under 55, male and female,
living and working in Europe, with some investment experience to secure some
familiarity with mathematics and probability. The rationale behind that decision
was based primarily on the findings of Grether (1978) and Grether and Plott
(1979). The authors document that information processing violations of Bayes’
rule is more common among inexperienced and financially unmotivated decision
makers, than between financially literate decision makers with some incentive or
motivation. Along the same lines Reynaud and Couture (2010) conducted their
research on lottery preferences using farmers as respondents, because farmers
are a group of professionals used to making important decisions facing
uncertainty (on the weather, the international grain prices, etc.). Experienced
investors are also familiar to probability-based decision making, which
contributes to the goal of obtaining truthful, calculated, accurate data, free from
misunderstandings, cognitive limitations and biases.
Preliminary sampling for this questionnaire verified this assumption, because in

pilot rounds with subjects unfamiliar with economic and mathematical terms
such as probabilities and payouts had difficulty stating their true willingness to
pay and willingness to sell prices, and required some extra effort and more
sample questions before their answers became accurate. A noteworthy
observation was that this behaviour was not due to lack of rationality,
unreasonable preferences or extreme risk appetites, but merely due to a delay in
the understanding of what is required and a difficulty in expressing true
willingness to pay levels.
It was also evident that subjects with no trading experience had difficulty
categorizing probabilities and displayed inconsistencies in their responses, many
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of which were irrational (for example, paying more to play a lottery than that
lottery’s maximum payout). Upon explanation of striking irrationalities, these
subjects gradually corrected themselves to provide a healthy variety of data that
made sense, but which were compromised by multiple interventions in the
procedure. Subjects with no trading experience, who displayed the
aforementioned difficulties, gradually converged to approach the decision
making patterns displayed by active or passive investors with some financial
literacy. They did, however, require extensive explanations and clarifications,
some of which were directive rendering the data biased, and therefore unusable.
The concluding assumption is that financial literacy is a necessary prerequisite

for eligibility in this sample and all subjects should be able to grasp the concept
of probability, as well as view gambles and lotteries as risky monetary outcomes,
much like stock investments. In retrospect, and despite the statistical analysis
limitations of a uniform sample, I believe the decision to restrict the sample to
investors was a wise one, as it saved time and improved the reliability of the
data.
5.2 Introducing the Experiment
The questionnaire39 aims to reveal preferences among risk prospects of various

risk and payout levels.
Subjects performed the following four tasks:
i. Categorise amounts by level of significance,

ii. Rank various lotteries,
iii. Offer to buy various lotteries, and
iv. Offer to sell various lotteries.
Each task aims to reveal specific aspects of risk perception and appetite, as well
as to produce evidence on the relatively under-researched importance of payout
levels on the construction of preference. The sample comprises 52 professional
or individual investors, featuring financial literacy. A total of 52 completed
39 The questionnaire is presented in Appendix B.
90
questionnaires and nobody refused to participate - so the results are free from
selection bias. The number of participants is low due to the complexity of the
required tasks, but the accuracy of the results provides ample compensation for
the limited sample size, as discussed below.
5.2.1 Background Information
The questionnaire begins with a collection of background information questions,

including self-assessment regarding risk appetite and wealth levels.
Demographic information is always important in statistical analysis, all the more
so when complex characteristics such as risk appetite are being examined.
Indicatively, personal information such as marital status and information on the
subjects’ sources of income adds insight towards the creation of risk profiles. For
example, a single parent who supports three children and has no sources of
income other than his/her profession might perceive the prospect of losing €100
in a lottery very differently than a single, wealthy professional with some cash
flow streaming from owned property lettings.
Some information regarding stock market investment experience is also

required. Investment activity is important as firstly it documents some financial
literacy and secondly it ensures that the subjects are familiar with to the
concepts of risk and uncertainty. By extension, investment experience indicates a
minimum level of understanding of probability, which in turn promotes the
accuracy of the responses and their revealed and stated preferences40.
5.2.2 Categorisation of probabilities
Subjects were asked to characterize various likelihood levels in terms of

probability ranges. This section serves as an introduction to the setup of the
important questions that follow, which incorporate percentages and payouts, but
more importantly it puts subjects in the frame of mind that is required in order
to complete the questionnaire with consistency and attention. Subjects assigned
ranges of probabilities which to them correspond to each of 5 likelihood levels,
40In the pilot sessions it was quite evident that responses were more efficient among subjects
with financial literacy and familiarity with the principle of risking money for a chance to win
more money.
91
ranging from very unlikely to almost certain to occur. The purpose of this section
is, in part, the familiarization of subjects with the concept of probability, and also
the confirmation of their understanding of probability and the likelihood each
probability bears.
5.2.3 Categorisation of amounts
In this section subjects label amounts according to the significance they bear for
them using 5-point Likert scales: “Very Significant”, “Significant”, “Not Very
Significant”, ‘Insignificant” and “Very Insignificant”. The subjective importance of
a payout to an individual is hereby determined in order to establish that subjects
are neither overwhelmed nor left indifferent by the payout of each lottery.
This categorisation does not depend entirely on the wealth level of each
individual. In fact, a very wealthy individual with a net worth of more than €2
million may consider €10,000 a significant amount, while an employee with no
owned assets and a moderate salary might consider €10,000 insignificant.
It has been documented in previous research that risk aversion levels rise along
with payouts (Binswanger, 1980; Kachelmeier and Shehata, 1992). The
significance of various amounts, however, is not the same across all economic
agents: Any amount that for one individual is considered a large amount may be
insignificantly low for another. More importantly, a large amount that is a
significant win for an individual, might be a very significant amount when it is a
potential loss. Although not explicitly stated in terms of significance levels,
reference dependent models such as cumulative prospect theory can
accommodate such considerations under the context of loss aversion.
The contribution of this section to the experiment is three-fold:
1. It documents that the amounts used in the sections that follow are not very
insignificant to the subjects. If they were, then the subjects might be
indifferent to the maximum payout and would potentially answer hastily, with
less enthusiasm and accuracy, leading, perhaps, to misleadingly low risk
aversion, or extreme risk aversion due to indifference.
92
2. It ensures relative uniformity of the significance of amounts among the

subjects, in the sense that all of them perceive very significant and very
insignificant amounts similarly. This is a prerequisite as all subjects are given
identical questions to answer, producing directly comparable results,
3. It familiarizes the subjects with the structure of the questions that follow,
together with the section that categorises probabilities.
The final section of this group of questions comprises the classification of

significance for loss amounts. The amounts previously classified in Likert scales
as profits were now converted into losses (negative numbers) and again subjects
assigned significance levels to each of the amounts. The scope of this exercise is
to examine if the perception of the significance of amounts is symmetric around
zero, or if the significance of an amount of the same magnitude varies based on
whether the amount is a possible (or certain) gain or a possible (or certain) loss.
In order to ascertain the difference between the assigned significance of amounts
of gains versus losses, the difference in significance was tabulated against the
amounts. In the absence of any negative changes (i.e. more significance assigned
to the gain amount than to the loss amount), this tabulation was conducted over
four levels of change in significance (0, +1, +2, +3 changes) for each pair of
amounts. If no difference is present, then the distribution would be uniform
across all amounts. On the other hand, if the change in significance assigned is a
function of the amount, then the distribution will show a changing pattern. As
discussed in the relevant section 5.5 on statistical inference later on, this change
can be detected by Fisher’s exact test, which confirms a significant asymmetry in
the stated significance of gains and losses in the sample.
5.3 The Rankings Section
This section comprises various lottery bundles and asks subjects to rank them by
order of attractiveness. All lotteries in all bundles are win-only lotteries, no
negative payouts are included.
This group of questions achieves the following:
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 It confirms which amounts are truly significant to the subjects - their risk
aversion increases along with the significance of the payouts,
 It determines if the subjective significance subjects allocate to the payout
amounts of lotteries has an impact on the risk they are willing to undertake,
 It reveals the ordinal preferences of the subjects and indicates their level of
risk aversion,
 It determines patterns in the variability of implied risk aversion.
The first section aims at revealing risk appetite through the ranking of lotteries
by order of attractiveness. The technique is similar, but not identical, to the
Ordered Lottery Selection method. I decided against using a Multiple Price List
format, to avoid anchoring41. Subjects are asked to rank the lotteries in each of 6
bundles by order of attractiveness. Each bundle contains lotteries of the same
EV, which varies from very insignificant (€30) to significant (€30,000). I chose
this method to measure risk appetite combined with variations of other methods
described in the following sections, because the required tasks are
straightforward, direct and leave little room for misunderstanding.
The section comprises a total of 30 pairs of outcomes, and asks subjects to rank
the prospects (in each of 6 lottery bundles with the same EV) by order of
attractiveness. The question was presented as follows:
“Consider you are offered the following lotteries. Please rank them by
order of attractiveness, assigning 1 to your preferred option, 2 to the
second-best option, etc.”
The questions take the form:
[Win €100 with 30% probability, else win €0]
To promote understanding, a visual simile was offered whereby subjects were

asked to imagine an urn containing 100 tokens, 30 of which featured a €100 WIN
mark and 70 of which featured a €0 WIN mark. The subjects would pick one
token out of the urn, and win the amount marked.
41Anchoring refers to the tendency of respondents to provide values around the values listed in
the Multiple Price List, resulting in some bias in the responses.
94
Upon conduction of the interview, all subjects appeared to fully understand the
required task, and to be comfortable with ranking the lotteries.
The lotteries in each bundle have the same expected value and six groups of
lotteries are presented as follows:
 Four bundles comprising six Lotteries of equal EVs. These lottery bundles
(hereafter LBs) are referred to as and their
corresponding expected values are set at:
.
 Two bundles comprising three Lotteries of equal EVs. These bundles are
referred to as and and their expected values are
and .
As implied in the EVs of these LBs, each of the lottery bundles’ EVs bore different
significance in terms of payouts:
 Two lotteries with payouts ranging from ‘not very significant’ to

‘insignificant’ ( )
 Two lotteries with payouts ranging from ‘insignificant’ to ‘very
insignificant’ ( )
 Two lotteries with payouts ranging from ‘very significant’ to ‘significant’
).
This was done in order to test the impact of the magnitude of the prospective
payouts on risk appetite. Coupled with the constant EV across all lotteries in each
LB, the ordering assigned to LBs with low EVs can be compared to the ordering
assigned to LBs with high EVs. As these orderings are indicative of risk appetite,
the impact of the significance of the payouts on risk appetite is revealed.
The lotteries in each bundle included a win payout and a zero payout, so none of
the lotteries featured any losses. The primary assumption is that subjects
revealing a preference for the high payouts/low probability pairs indicate a
positive disposition for risk. High risk aversion is exhibited with a preference for
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the lotteries which feature a high probability for a win, although the maximum
gain of these lotteries is low compared to other lotteries in the bundle.
The middle Lottery, 42, shall be considered henceforth as the root lottery in
this analysis, a suitable choice as none of the payouts in any of the lotteries in
this bundle is very significant or very insignificant. The relationship between the
payouts and the probabilities in the bundle is the following:
:[ , ], :[ , ], :[ , ], …, :[ , ].
With held constant (in this case equal to €1,500) and probabilities in
increments of 15%, lottery bundle LB is presented in Table 5.1 below.
Table 5.1: The Lotteries of Bundle LB
Lottery High Probability Low Probability

Payout [ ] Payout [ ] Rank
[
€10,000 15% €0 85% €1,500 6
€5,000 30% €0 70% €1,500 5
€3,350 45% €0 55% €1,507.5 4
€2,500 60% €0 40% €1,500 1
€2,000 75% €0 25% €1,500 2
€1,650 90% €0 10% €1,485 3
determines each of the six lotteries in the LB,
lists the desirable payout of , lists the undesirable payout
lists the probability of winning , and
lists the expected value of each .
EVs are all around but not necessarily exactly equal to €1,500. The decision to
keep the payout levels “round” instead of “rounding” the EV to exactly €1,500
was based on the assumption that the latter would lead to a non-rounded payout
in these lotteries. To illustrate, for to be exactly €1,500, the high payout of
would have to be €1,666.67.
The most unlikely outcome is therefore the highest outcome, with 15%
probability of occurrence, labelled , and the most likely outcome with a 90%
chance of occurrence, labelled is . Notice the use of probabilities around the
42 Henceforth I shall refer to LB and interchangeably.
96
equi-probable mark, to avoid anchoring on the round and familiar probability

level of “50-50”. With highest payout of the lottery be and the lowest
probability . Up to prospects have an so the probability of winning
is lower than the probability of not winning. From onwards, and the
risk of not winning decreases.
In order to examine the preferences of decision makers among this bundle of k

lotteries with an EV of y, the key assumption is that a risk averse decision maker
would rank his preferences starting with a preference for the lottery with the
highest probability of winning, i.e. . If there is a
significant relationship between the EV of the lottery and risk appetite, then
introducing some changes in y upwards or downwards would result in changes
in preference orderings. Similarly to Holt and Laury (2002), we assume three
additional Lottery Bundles as follows:
(22)
(23)
and
(24)
The table below summarizes the components of lotteries contained in the high
EV lottery bundle comprising , and in the low EV lottery bundles
comprising and respectively:
Table 5.2: Summary of Lottery Bundles in Rankings Section
Probability of Probability of
EV Max Payout Min Payout
Max Payout Min Payout
Statistical tests for the above differences are carried out at each Lottery Bundle
level and at a Lottery pairs level, as described in later in Section 5.5.
97
I analyse the four lotteries of six outcomes and record the ranking
responses of the each subject in each of the four bundles. The rankings are coded
in six-digit numbers, each number corresponding to the rank given to each of the
six lotteries by each of the subjects. To illustrate, in the “Rank” column of Table
5.1 I present the rankings of Subject No. 42 in this lottery bundle
The rankings of this individual are recorded as a single 6-digit number ‘654123’.
A respondent with preference to the prospect with the highest payout and the
lowest probability, then the second highest payout and the second lowest
probability, etc. would be assigned the number ‘123456’.
Each of these six digit numbers indicate a risk preference, with ‘123456’
implying a preference for the riskiest prospect, and ‘654321’ implying a
preference for the least risky prospect. With this labelling, we rank individual
responses by risk preference reflecting that an individual assigning ranks
‘653412’ is more risk averse than an individual assigning ranks ‘123654’.
The coding procedure described above yields digit codes of various

combinations for each , depending on the number of Lotteries in each bundle.
As a result, lottery bundles resulted in six digit codes and lottery
bundles resulted in three digit codes. This coding is simplified
further on the basis that a ranking of 1, indicating a preference for this lottery
above all other lotteries in the LB, makes a “stronger” statement than a ranking
of 6, which indicates the least preferred lottery. More importantly, the statement
of preference incorporated in the difference between 1st and 2nd place is stronger
than the difference between 5th and 6th place. At the same time, the difference
between 1st and 2nd place is smaller than the difference between 1 st and 6th. This
assumption is even more valid given that these lotteries contain no negative
payouts and can only result in an unchanged or improved final wealth. As a
result, a ranking of 6 does not imply an aversion to the lottery, but rather
indicates that one would prefer the five other lotteries if offered the choice.
The 6 digit rankings were then converted into 3 digit rankings in order to assign
a stronger “statement value” to high ranks, and a lower value to lower ranks.
This grouping simplifies the analysis and at the same time allows for a direct
98
cross-check comparison with the results of the 3-lottery bundles and .

This grouping comprises the separation of each six-digit code into three two-
digit pairs, with each of the pairs corresponding to the first, second and third
digit of the new code. Then, each pair was recoded keeping the dominant rank,
i.e. the lower of the two numbers in the pair. Some examples of the
aforementioned grouping in action are available below:
 Rank Code 624153 is recoded as 213, as follows:

o 62 becomes 2
o 41 becomes 1
o 53 becomes 3
o 26 becomes 2
o 45 becomes 4
o 31 becomes 1
We then assign “1” to the smallest value, “2” to the middle value (in
this case 2) and “3” to the highest value (in this case 4).

o 65 becomes 5
o 41 becomes 1
o 23 becomes 2
Numbers 1 and 2 are preserved and number 5 is the lowest, so it is coded

as “3”.
Recoding confirmation was conducted with a test of proportion to confirm the

consistency of the data. The test of significance was also addressed using the
percentages of each ranking sequence within each lottery bundle (i.e. the
distribution of the ranking sequence values within each lottery bundle). This
comparison was carried out in the following manner: For each subject, each EV
level was coded as a variable taking values from the permutations of 1, 2 and 3.
Thereby, the distributions of the particular permutation values correspond to
the risk related with the particular EV level can be used as measures of the
99
relationship between risk appetite and lottery EV. If there is no relation, then the
distribution will be the same across lottery EVs. If there is a relation, it will be
expressed as a reversal of distributions (from 123 to 321). One appropriate test
is Fisher’s exact test for independence, especially since some of the table cells
have expected count smaller than 5, rendering the more commonly used chi-
squared test invalid. The results of this test are presented in Appendix C, Table C-
3 and indicate a full compatibility in the 6-digit and 3-digit rankings.
The preference ordering and its relationship with the riskiness of the prospect
depends on the inherent risk of each of the lotteries. We construct this measure
of risk using what we call the equiprobable equivalent, calculated for each
of the lotteries and defined as the expected value of a prospect with the same
high and low payout but probability of 50% for both payouts as follows:
(25)
This measure can serve as a point of reference, departures from which

determine the risk incorporated in each Lottery, as follows: is the expected
value of a Lottery with two equally probable payouts and . For example,
consider described earlier in Table 5.1. In this case, and
, and the resulting equiprobable value of is:
(26)
However, given the probability distribution of L, the expected value of the

lottery is given by:
(27)
The relationship between the equiprobable value of the lottery and the expected
value of the lottery can be used to measure the “distance” of the lottery from risk
neutrality. In the example of , the lottery has an EV that is much lower than its
equiprobable value. This happens because the probability of winning, i.e. the risk
incorporated in the lottery, is smaller than 50%. In other words, the lottery is
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“riskier” than the equiprobable lottery, and this “riskiness” is expressed as the
difference between the lottery’s EV and its EQ.
To that effect, I define as follows:

(28)
As stated above, for
=>
(29)
Obviously, for .
The simple calculation of can serve as the ordering of riskiness. As

moves into the positive domain, increases and decreases indicating a
gradual decrease in riskiness along with corresponding maximum gains.
5.4 Contingent Valuation
The background information section requires only basic information and all
sensitive information (for example income levels) is optional. Probabilities and
numbers are introduced gradually, so subjects become familiar with the
formatting of the questions by the time they reach the cognitively intensive and
more sensitive sections. The rankings tasks comprise entirely hypothetical
lotteries, but variations in payout amounts induced interest and subjects had no
incentive to lie or misstate their true preferences. The very little cognitive effort
required to comprehend and respond is an indication of what we believe to be
reliable data collection.
My aim in the contingent valuation section, which is the most important and
“difficult” section of the experiment, was to remove as many biases and
misunderstandings as possible. This was achieved through a straightforward
questionnaire layout that promotes transparency and trust on behalf of the
subjects. The pricing tasks were set up to appear one at a time and featured a
very simple, albeit long, set of questions, clearly stating the stakes and given
probabilities. The decision problems were of the form [Win €10,000, 15%
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chance; Win €0, 85% chance] and all lotteries were binary lotteries involving
only two potential outcomes.
Finally, an important consideration was the provision of incentives, which I

believe to be a key driver of truthful, accurate answers. In the bidding section
which is the most sensitive to miscalculations and misunderstanding, we
provided ample, as the highest bidder in the bidding section would be granted
the lottery ticket and be paid out if won. This incentive bears some added
benefits in terms of data reliability: It urges subjects to answer truthfully, but to
not exaggerate as the amounts at stake are significant and any exaggeration – for
example an overstated bid price that the subject would be unwilling or unable to
pay – are not insignificant amounts to the decision makers.
5.4.1 Willingness to Pay
The “Willingness to Pay” tasks comprise up to five sections. The subjects are
asked to state the maximum amount they would be willing to pay to participate
in several lotteries. The method we use to extract the WTP values is a hybrid
method and we ruled out MPL due to its inherent limitations presented earlier.
Having considered Andersen et al.’s (2005) variations to correct some of the
problems of MPL, the weaknesses of the method remained and indeed, when
dealing with large amounts, these effects are amplified, impairing the validity of
the results. This is potentially one of the reasons why the method is applied
primarily on choice problems with small payouts. Perhaps more importantly in
terms of perspective in the conduction of the experiment, MPL could induce
anchoring, in which case the isolation of the anchoring effect in order to infer
conclusions from the collected data would be a rather tedious exercise.
Moreover, a careful selection of payouts and probabilities can reduce – albeit not
remove – a number of biases and effects that could impair the validity of the
data.
Pricing tasks in this section are based on the lotteries of presented earlier in
Table 5.1. The EV of this lottery bundle is set at €1,500. In an investment
analogy, these prospects replicate options with the same intrinsic value
(assuming the time value of these theoretical options to be the same).
102
In terms of incentives, the payout amounts used in this LB are neither very
significant, nor very insignificant to the subjects. This is confirmed in the data
collected in relevant section comprising the categorisation of amounts. If these
payouts were too high and almost certain to occur, eg. a 90% probability to win
€2,000,000, then the subjects would bid the maximum price they could afford,
not the true value they attach to the prospect. In other words they would state a
price directly relative to their wealth level, biased with feelings of euphoria or
biased with the profound reminder that this is a hypothetical question.
On the other hand, if the maximum payout was too low, i.e. very insignificant to
the subjects, their attention would be compromised. They would most likely
provide a casual answer that might not correspond to their true willingness to
pay, probably exhibiting risk-seeking behaviour that would reduce the research
value of the empirical results. Another reason why we chose moderately
significant amounts is our profound commitment to offer real payouts. As an
extra incentive for stating the truly highest possible price they would be willing
to pay, the highest bidder would actually play the lottery and potentially win the
stated amount. All subjects in the set found the prospect appealing.
For the lottery bundle , comprising lotteries defined over such that
1)
2) and
3)
As a result is the riskiest lottery in because it is the lottery with the lowest
probability of a win, and is the safest lottery in , based solely on the
probability of winning the highest of the two payouts.
We assume that a preference ordering is possible for whereby

preferences are complete, transitive and monotonic. As a result, ∀ :
 or or both
 If and , then
 If , then
103
Let be a measure of cardinal preferences with the same properties as

but with L transformed into equivalent monetary values.
Let be the certainty equivalent of L, defined as the monetary value at which

the decision maker would both buy and sell lottery L. We assume .
Furthermore, rationality imposes the following restriction:
(30)
meaning that cannot be higher43 than the maximum payout of L and cannot
be lower than the minimum payout of L, irrespective of risk appetite.
For the specific case of risk neutrality, we assume , and we define

extreme risk aversion as
(31)
with =current wealth, implying that maximum risk aversion of a rational

decision maker is a minimum WTA equal to the minimum payout of L. For
example, in the decision maker with maximum risk
aversion would be willing to accept €0 to sell this lottery ticket.
We define extreme risk seeking as
(32)
In other words, the maximum amount a decision maker is willing to pay to

purchase the lottery ticket is equal to the maximum payout of the lottery ticket.
In the above example of , the extreme risk seeker would be willing to pay a
price of €3,350 to purchase the lottery ticket.
The procedure for the extraction of introduced in this methodology aims at

an accurate approximation of the certainty equivalent. We present subjects with
a lottery bundle containing lotteries with the same expected value: and
43 is often assumed to be equal to Willingness to Pay (WTP) and/or Willingness to Accept

(WTA) prices, but actually and as
104
. Subjects are asked to provide the maximum

amount they are willing to pay, to play each of the lotteries. The resulting
set of prices,
=[
is expected to follow the same preference ordering as , with the highest

ranked being assigned the highest price and the lowest ranked being
assigned the lowest price.
The goal is to detect any significant value change across the Lottery Bundle, but
also between Lotteries in the bundle. To that effect, we use the Wilcoxon rank
sum test (Kruskal-Wallis test approximation).
5.4.2 Sequential Willingness to Pay
The amount the decision maker is willing to pay is a prospective cash flow that
essentially transforms the win-only lottery into a mixed lottery. Assuming the
decision maker states their true maximum WTP in each of the lotteries, we
obtain and the respective EVs change accordingly as follows:
( )
(33)
We expect that if is truly the maximum bid price the subject would offer
for , then incorporating into would produced an equivalent lottery

as follows:
=
(34)
( ) ( )
Let be the price assigned to . If is the true maximum amount subjects
are willing to pay for , then . If , then the stated cannot
be the maximum bid price of If , then and is now a
mixed lottery with potential losses equal to
105
The resulting lottery bundle, labeled contains the same lotteries with each of
the payouts reduced by Subsequent sections reintroduce each of the
lotteries of the as described in the table below.
Table 5.3: First Step in Sequential Equivalence Willingness to Pay
Lottery High Payout Probability Low Payout Probability

[ [ ] [ ]
- 15% -€ 85% -€
- 30% -€ 70% -€
- 45% -€ 55% -€
- 60% -€ 40% -€
- 75% -€ 25% -€
- 90% -€ 10% -€
As subjects name their price they move on to the next set where the above
technique creates a new group of lotteries:
(35)
and so on, until , where is the index of the Lottery where the
bidding ends.
When , the decision maker is only willing to play the lottery if it was
available to him for free. At that point, that particular is withdrawn from
subsequent bundles. As a result, if on the six Lotteries of a subject declares a
willingness to pay €0 for two of the lotteries, then the next set, , would
contain only the remaining four lotteries for which the subject stated a non-zero
price. This is done for two reasons: Firstly, to avoid the repetition of the same
lottery in the remaining steps of the questionnaire, which could reveal the
connection between the questions to the subjects. Secondly, to avoid
inconsistencies and confusion, as the goal was not to “trick” the subjects, but
rather to induce them to reveal their true preferences.
From lottery bundle onwards, where lotteries contain a positive and a

negative payout (as opposed to LB which contained a zero and a positive
payout), subjects can also state that they “would not accept this” prospect, an
option subjects choose if they would not participate in the stated lottery, not
106
even for free. As with the lotteries with a declared willingness to pay of €0,
lotteries labelled “would not accept this” are also removed from the next set of
prospects.
Finally, although some subjects could potentially continue to pay for the lotteries
for several sessions, a maximum number of five WTP sets of lotteries are
provided.
The cumulative amount subjects are willing to pay for each of the lotteries in the
sequence, SWTP, is calculated until the subjects state a price of €0 or refuse to
play the lottery. The resulting sequential lottery bundle is labelled SLB and the
final lotteries in SLB, labelled comprise all cumulative sequential WTP
amounts as presented in Table 5.4 below.
Table 5.4: Sequential Equivalence Lottery Bundle SLB
Lottery High Payout Probability Low Payout Probability
[ [ ] [ ]
- 15% -€ 85%
- 30% -€ 70%
- 45% -€ 55%
- 60% -€ 40%
- 75% -€ 25%
- 90% -€ 10%
where the sequential WTP, SWTP, is defined as:
(36)
with each reframed lottery is labelled as .
In terms of the certainty equivalent, we expect that the sequential willingness to

pay can approximate the certainty equivalent of the prospect, as follows:
∑ (37)
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Incorporating to obtain a lottery equivalent of , labelled the

equation becomes:
[( ) ( )( )]
(38)
( ∑ ) ( ∑ )
Very early on in the questionnaire response collection process it was evident

that many people reached the fourth set of questions and even the fifth, without
making any connection between the lotteries. As a result, the data set and the
analysis that stems from it achieve multiple goals, namely:
 It documents the existence of framing, a well-researched bias often

responsible for deviations from rationality.
 It tests risk aversion and directly compares risk aversion in gains-only and in
mixed lotteries.
 It provides motivation and incentive for thoughtful, accurate answers, and
subjects have the financial literacy to oblige. Payouts in the gains-only
lotteries are real, but will only be paid to the highest bidder.
 It tests the accuracy of WTP prices and indicates that subjects generally
overestimate their risk aversion.
 It introduces the sequential equivalence method for the extraction of WTP
which apparently leads to a better approximation of certainty equivalence.
5.4.3 Willingness To Accept (WTA)
The final section of the questionnaire asks subjects to name their price in order
to forego the opportunity to participate in a lottery. The section comprises three
sets of lotteries: The first set of lotteries contains lotteries with the same payout,
i.e. and as in . This section serves as a check point, to ensure the
subjects understand the task and follow a smooth transition from WTP to WTA
requirements. The second set of lotteries is the of the WTP section presented
above. The third set of lotteries is SLB described in the table above. This last set
serves as a confirmation that the SWTP prices that have accumulated in the
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relevant section of the questionnaire produced a lottery which bore some value
for the subjects. If the SWTP prices exceeded their true maximum willingness to
pay, then the subjects would provide a zero price (essentially giving the lottery
away for free).
Turning to the extraction of WTA prices, , subjects price each Lottery

Bundle and obtain as follows:
=[
The compensation each subject requires to give up his participation to the

lottery is another manifestation of certainty equivalence, this time with a risk
premium added to it. This leads to an expected:
5.4.4 Comparative Analysis
Extensive comparisons and their statistical significance shall be conducted

between:
a) WTP and SWTP

b) WTA and WTP
c) WTA and SWTP
d) The CEFs of the above.
Indicatively, any difference between the initially stated WTP widely used in prior
literature experiments and the sequential WTP calculated in the methodology
discussed in this study is calculated as:
(39)
And the cumulative SWTP expresses the cumulative difference between the
initial and the final bidding of the subjects:
(40)
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Finally, we shall discuss the relationship between certainty equivalents and

show that through sequential equivalence the contingent valuation gap is
reduced and a better approximation of the certainty equivalent is achieved.
(41)
Finally, we shall compare the CEFs derived from the contingent valuation tasks
and discuss the information that any disparities reveal. For instance, as
discussed earlier, loss aversion has been defined in many ways and indeed many
of them provide valuable simplifications for variables that are otherwise difficult
to calculate. We believe that in the analysis of prospects with monetary outcomes
such as lotteries, where various measures are directly comparable by being in
the same units (of money, instead of comparisons between goods or services or
between goods or services and money), evidence of loss aversion widely
calculated as Kahneman and Tversky’s (1979) “λ” can also be found in the simple
and effective estimation of CEF values. We shall apply equation (16) to calculate
the CEF values drawn from the WTA section, from the WTP section and the
SWTP values. In the absence of loss aversion, these CEFs should be similar, i.e.
(42)
Perhaps more important, excluding any income or wealth effects, is the

comparison of CEF values within the SWTP procedure. When values are collected
comparing mixed lotteries, all CEFs refer to prospects featuring decreasing gains
and increasing losses, indicating the impact of loss on the bid price.
5.5 Statistical Analysis
The statistical analysis of the key hypotheses in this thesis is conducted using
non-parametric tests. The advantages of non-parametric tests that led to their
choice as more appropriate for the statistical inference of this analysis include: i)
ease of use with all scales, ii) adaptability in smaller sample sizes, iii) they do not
require population parameters and iv) produce same validity of results as
parametric procedures. In Table 5.5 below we list the hypotheses tested,
presented by section, and the corresponding tests conducted.
Table 5.5: Statistical Tests per Section
110
Section Observation Hypotheses Test

Difference
: No difference in proportions
btw stated
Significance across amounts Fisher’s Exact
significance of
of Amounts : Difference in proportions Test
gains vs
across amounts
losses
: The proportions of the 6-digit
Recoding of 6-
rankings are equally distributed
lottery
across the 3-digit ones. Fisher’s Exact
bundles into
: The 6-digit rankings are Test
3-lottery
clustered around the
bundles
corresponding 3-digit rankings.
Risk Aversion
: Median rankings are the same
changes when
Ranking across Expected Values Fisher’s Exact
payout
: Median rankings are different Test
amounts
across Expected Values.
increase
Risk aversion Kruskal –
: Median rankings are the same
increases Wallis One Way
across pairs of Lotteries
when payout ANOVA Test
: Median rankings are different
amounts and Wilcoxon
across pairs of Lotteries
increase Rank Sum Test
Significant : There is no significant value
Wilcoxon
disparity change between WTP and SWTP
Signed Rank
between WTP : There is a significant value
Test
and SWTP change between WTP and SWTP
Significant : There is no significant value
Wilcoxon
disparity change between WTA and WTP
Signed Rank
between WTA : There is a significant value
Test
and WTP change between WTA and WTP
Contingent Significant : There is no significant value
Wilcoxon
Valuation disparity change between WTA and SWTP
Signed Rank
between WTA : There is a significant value
Test
and SWTP change between WTA and SWTP
: There is no significant value
Significant
change between and
disparity in Wilcoxon
CEFs between Signed Rank
: There is significant value
WTP and Test
change between and
SWTP
The statistical significance of the relationship between risk aversion and payout
change are assessed using Fisher’s Exact Test. The rationale behind the use of
this test is the nature of the data. Firstly, the sample size is relatively small.
Secondly, the test is suitable for classification data such as the ranking data in the
111
questionnaire. Thirdly, Pearson’s chi-squared test cannot be applied because

many of the observations have recorded frequencies < 5.
The comparisons of changes in the relationships in pairs is assessed using

Wilcoxon Rank Sum Test. This test was chosen as an appropriate measure for the
data, which included ranks. Also, this test does not require normality and that
can accommodate small expected values in multiple cells.
The significance of the differences in valuations is assessed using Wilcoxon

Signed Rank Test. This test was chosen due to the nature of our dataset, as
mentioned above.
112
Chapter 6 Key Findings on Revealed Preference
Chapter 6 - Key Findings on Revealed Preference
This chapter presents and analyses the data collected using the methodology
described in the previous chapter. In brief, we find conclusive evidence on the
following, all of which are extensively discussed later on:
a) The significance of amounts is asymmetrically assessed. We find substantial

differences in the significance attached to gains and to losses of the same
magnitude. The supporting data is drawn from all sections of the
questionnaire.
b) There is a significant interaction between risk appetite and the level of the
payout amounts. This evidence is drawn from the data collected in the
Rankings section and indicates that as payouts increase, risk aversion
increases and safer options are preferred.
c) Evidence of underestimated WTP values indicates that decision makers
often overestimate their risk aversion. An improved evaluation of propensity
to risk is revealed through the sequential equivalence methodology.
d) The efficiency of the sequential equivalence method bridges the gap between
WTP and WTA.
e) The “endowment effect” is extracted using data drawn from the contingent
valuation section. The impact of the endowment effect can be contained
using the sequential equivalence method.
f) The principle of loss aversion is documented, and the sequential equivalence
data can be used to produce a non-parametric estimation of the loss aversion
coefficient.
6.1 Evidence of High and Low Significance
Subjects labelled amounts by assigning significance levels to them in the context

of a Likert scale. The results of this exercise are presented in Appendix C, Table
C-1. Upon comparison of each pair of significances per subject it is evident the
stated significance of a gain is often lower than the stated significance of the
113
same amount when that amount is a loss. This effect evens out as amounts
increase, and very significant gains – in this case €2mil - where both gains and
losses are considered “very significant”.
The shift of significance upwards when the same amounts are considered as
losses instead of gains, is striking. None of the subjects has indicated any amount
to be less significant as a loss than as a gain, out of the 8 (in absolute terms, 16 in
total) amounts considered.
The change in the assigned significance (tested using Fisher’s exact test which
confirmed the impact of payouts on assigned significance) is presented in the
table below. As no one in the sample assigned a smaller significance level to any
of the loss amounts compared to the corresponding gains amounts, the
significance level changes listed in the table refer to stated increases in
significance of the loss amount compared to the gains amount. For instance, row
2, column 3 states that 15 subjects stated that a -€3,000 loss is by 2 levels more
significant to them than a gain of €3,000.
Table 6.1: Changes in Significance of Amounts for Gains and Losses
Change in +1 +2 +3
significance No change significance significance significance
Amount level levels levels
+/-€ 100 32 (61.5%) 20 (38.5%) 0 (0%) 0 (0%)
+/-€ 3,000 13 (25%) 24 (46.2%) 15 (28.9%) 0 (0%)
+/-€ 10,000 13 (25%) 27 (51.9%) 12 (23.1%) 0 (0%)
+/-€ 30,000 19 (36.5%) 27 (51.9%) 5 (9.6%) 1 (1.9%)
+/-€ 70,000 12 (23.1%) 32 (61.5%) 8 (15.4%) 0 (0%)
+/-€ 100,000 15 (28.9%) 36 (69.2%) 1 (1.9%) 0 (0%)
+/-€ 500,000 44 (84.6%) 7 (13.5%) 1 (1.9%) 0 (0%)
+/-€ 2,000,000 52 (100%) 0 (0%) 0 (0%) 0 (0%)
Total 200 (48.1%) 173 (41.6%) 42 (10.1%) 1 (0.2%)
As indicated, less than half of the subjects give the same significance to gain and
loss amounts. In fact, while for very large amounts the stated significance is the
same for gains and losses, the vast majority of subjects ranks losses at least 1
level of significance higher than gains. This is more clearly exemplified where the
very significant gains amount of €2mil and €0.5mil are excluded: excluding very
114
significant gains, an astonishing 71% of subjects label an amount more

significant as a loss than as a gain.
Clearly, the following evidence of asymmetric significance of amounts emerge

(indicated in red in the table above):
 For very small amounts (€100) and very large amounts (€500k+), no change
in significance is recorded.
 Most of the two-step changes are recorded in the small amounts
categories(€3,000 and €10,000).
 One-step changes are more or less uniformly distributed across amounts in
the ranges between €100 - €100,000.
 Finally, moderate amounts (between €30,000 and €100,000) exhibit the
majority of the one-step changes in significance.
The statistical significance of the finding was tested using Fisher’s exact test and
documents a strong statistical significance with a p-value <0.00005. This result is
also presented in cumulative terms in the table below. The total responses
labelling a “very significant” gain is nearly half of the total responses labelling a
“very significant” loss. This clearly points to the fact that gains are less significant
that losses of the same magnitude.
Table 6.2: Cumulative Significance
Very Significant Not Very Insignificant Very
Significant Significant Insignificant
G L G L G L G L G L
+/-€ 100 2 2 18 38 32 12
+/-€ 3k 4 29 20 20 24 3 4
+/-€ 10k 2 10 45 30 5 12
+/-€ 30k 4 17 19 32 25 3 4
+/-€ 70k 12 51 32 1 8
+/-€ 100k 15 52 36 1
+/-€ 0.5m 44 52 7 1
+/-€ 2m 51 52 1
Total 126 226 109 107 87 30 58 41 36 12
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Observe the first two columns of the table above. The total number of “very
significant” losses is almost double the total number of “very significant” gains.
As the same amounts were presented as gains and as losses, this disparity
indicates that significance levels are more sensitive in the loss domain than in
the gains domain.
The results of the statistical analysis confirm a significant difference in proportions

across amounts, ad a rejection of the null hypothesis
There is an implied asymmetry in the range of amounts that subjects consider

important gains and the range of amounts that subjects consider important
losses. This asymmetry could have very important implications on preference
and in both the qualitative and the quantitative analysis of implied risk appetite
as well as loss aversion. Going back to Rabin’s (2000) paradox, a behavioural
explanation based on the above discussion might be considered of why a
decision maker who rejects an even chance at a favourable bet might accept an
even chance at a different favourable bet of the same analogies. This explanation
has to do with the asymmetric significance of amounts, a concept that is tied to
loss aversion. The table below summarizes how the majority of the subjects
categorized the presented amounts.
Table 6.3: Implied Ranges of Significance
Amount Significance as a GAIN Significance as a LOSS

+/-€ 100 Very Insignificant Insignificant
+/-€ 3,000 Insignificant Not Very Significant
+/-€ 10,000 Not Very Significant Significant
+/-€ 30,000 Not Very Significant Significant
+/-€ 70,000 Significant Very Significant
+/-€ 100,000 Significant Very Significant
+/-€ 500,000 Very Significant Very Significant
+/-€ 2,000,000 Very Significant Very Significant
The implications of this asymmetric significance of amounts between gains and

losses are linked with the assumptions discussed in Section 6.6 below.
116
6.2 Rankings
With regard to rankings of attractiveness, when the subjective value of the

payout is low, i.e. the amount is insignificant, decision makers rank the near-
certain prospect low. Nevertheless, our findings suggest that as the amounts
increase and turn from insignificant to significant, risk appetite decreases and
subjects become increasingly risk averse. This predisposition towards risk
aversion as amounts increase indicates a higher attractiveness assigned to
prospects with the same EV, but lower risk. The recorded observations of the
rankings section are presented in Appendix C, Table C-2.
Risk appetite is implied in preferences and in this case subjects ranking the last
lotteries in each bundle first, indicating a preference for the lottery that offers
the lowest payout with the highest probability, exhibit risk aversion. In terms of
overall risk appetite, the majority of the subjects (50%44) revealed risk averse
preferences, as indicated in the figure below.
Figure 6.1: Cumulative Revealed Risk Appetite
123
- Risk Aversion +
27%
132
48% 213
1% 231
8% 312
321
14% 2%
In terms of changes in preferences, the table below shows a striking shift across
expected values, implying a corresponding change in risk aversion. This
observation is statistically significant 45.
44 This percentage is the sum of all subjects who ranked the safest option first.
45 The results of the significance tests are presented in Appendix C, Table C-4.
117
Table 6.4: Comprehensive Results on Lottery Bundles
Rank Total
EV=€30 EV=€150 EV=€1,500 EV=€2,500 EV=€30k EV=€30k
123 39 (75%) 29 (55.8%) 5 (9.6%) 6 (11.5%) 3 (5.8%) 1 (1.9%) 83 (26.6%)

132 0 (0%) 1 (1.9%) 0 (0%) 1 (1.9%) 1 (1.9%) 0 (0%) 3 (0.96%)
213 4 (7.7%) 6 (11.5%) 5 (9.6%) 4 (7.7%) 2 (3.9%) 4 (7.7%) 25 (8.01%)
231 0 (0%) 0 (0%) 6 (11.5%) 2 (3.9%) 0 (0%) 0 (0%) 8 (2.56%)
312 3 (5.8%) 4 (7.7%) 11 (21.2%) 12 (23.1%) 7 (13.5%) 6 (11.5%) 43 (13.78%)
321 6 (11.5%) 12 (23.1%) 25 (48.1%) 27 (51.9%) 39 (75%) 41 (78.9%) 150 (48.1%)
Each LB is defined by its EV and should have the same rank-sum under the
hypothesis of no difference between groups. The alternative is that each group
will have a different ranking sequence keyed to the expected value of the lottery
bundle (i.e. low expected lottery values will be associated with small ranking
sequences, implying lower risk aversion, while high expected lottery values will
be associated with large ranking sequences, implying higher risk aversion). It is
clear from the table below that the rankings of the ranking sequences increase
with the expected values of the lottery bundles, indicating that the higher the
expected value of the lottery bundle the higher the risk aversion. Using Fisher’s
Exact Test, the result is statistically significant with a p-value < 0.0001.
The prevailing observation is a shift in preferences from the most risky prospect
to the least risky prospect as payoffs increase. Through pair-wise comparisons
we obtain an indication of where this statistically significant difference lies. The
results are presented in the table below.
Table 6.5: The Statistical Significance of Differences in Risk Appetite
with with with with with with

p-values
EV=€30 EV=€150 EV=€1,500 EV=€2,500 EV=€30,000 EV=€30,000
with
EV=€30
with 0.0419
EV=€150
with <0.0001 <0.0001
EV=€1,500
with <0.0001 <0.0001 0.7341
EV=€2,500
with <0.0001 <0.0001 0.0063 0.0167
EV=€30,000
with <0.0001 <0.0001 0.0012 0.0035 0.6026
EV=€30,000
118
No statistically significant differences are recorded in risk appetite between

and (EV( and with p-value 0.7341. It
is no surprise that no statistically significant differences in risk appetite are also
not found between and (both with EVs =€30,000), with p-value 0.6026.
The rest of the pairs exhibit statistically significant differences.
Extending our previous discussion regarding the significance of amounts, the

lack of substantial difference in risk aversion between and may indicate
that the two EVs (€1,500 and €2,500) lie in the same range in terms of subjective
significance for the majority of the subjects. The same can also be inferred from
the lack of substantial difference between and , which have the same
EV=€30,000. The reversal of distributions (from 123 to 321) results in a U-
shaped figure of the relevant plots, as exhibited in the Figures 6.2 and 6.3 that
follow.
Figure 6.2: Rankings per Risk Level
45
40
Number of Respondents
35
EV=€30
30
EV=€150
25
EV=€1,500
20
EV=€2,500
15 EV=€30,000
10 EV=€30,000b
5
0
123 132 213 231 312 321
- Risk Aversion +
The prevailing observation is a shift in preferences from the most risky prospect
to the least risky prospect as payouts increase. The data clearly implies that risk
aversion increases along with expected values of the prospects, and the
significance test confirms the observed change in implied risk aversion.
119
Figure 6.3: Revealed Risk Appetite in Low and High Payout Bundles
Low Payout Bundle (EV=€30) High Payout Bundle (EV=€30,000)
2% 4%
5,8% 11,5% 6% 0%
123 123
0,0%
132 132
13%
7,7% 213 213
0,0% 231 231
312 312
75,0% 321 75% 321
The ranking given by the vast majority of the respondents in the lottery bundle
with lotteries of exhibited reduced risk aversion as the respondents’
top choice was the riskiest lottery – the one with the lowest probability to win
the highest amount. Fisher’s Exact Test46 yields a p-value < 0.00005. As a result,
we find that the impact of the level of the payouts on implied risk aversion is
statistically significant. As the expected value of the lottery bundles increases,
risk preference shifts from risk seeking to risk averse, clearly reflected in the
ranking of the lotteries. We therefore reject the null hypothesis that median
rankings are the same across Expected Values.
6.3 Valuations through Willingness to Pay
6.3.1 Willingness to Pay, Section 1 (Win-only Prospects)
In the first section of the contingent valuation group of questions, I asked

subjects to state the maximum amount they were willing to pay for the root
lottery bundle, all of which have an EV of €1,500. The results are presented in
Appendix C, Table C-5, organized in €50 intervals. One assumption is that the
higher the WTP, the higher the rank of a Lottery compared to the other lotteries
in the bundle. Since all lotteries have the same EV, the higher the probability, the
46 Chi-square is invalid as 96% of the cells have expected counts less than 5.
120
lower the payout. By extension, a higher price in and a lower price in

implies a preference for the safer prospect versus the riskier prospect. In turn,
such a preference ordering implies higher levels of risk aversion than the reverse
preference ordering.
Upon observation of the dispersion of the data, we notice that in the

concentration of amounts is in the ranges below €500, with 85% of the subjects
offering a highest bid below €100. On the other hand, the safest lottery in the
set exhibits the widest dispersion with amounts scattered relatively evenly
across the board up to €500 and even stretching beyond €1,000. This is evidence
that subjects displayed a preference for the less risky prospects. This indication
of risk aversion among the subjects may translate to a higher average price for
the safer lotteries. The table below validates this assumption and presents the
mean and median WTP values for each lottery.
Table 6.6: Mean and Median WTP
Lottery Mean WTP Median WTP

€85 €50
€101 €50
€152 €100
€180 €150
€235 €190
€318 €250
The median WTP was compared across lotteries using Wilcoxon’s rank-sum test.
The overall differences in values are significant, but a pair comparison presented
in Appendix C, Table C-6 indicates statistically significant differences between
the lotteries , , , and . The
differences between consecutive pairs of sequential lotteries (for example
between ) are not statistically significant. As a result, the median
SWTP is significantly different in increments of 2p.
121
The pricing ranking of LB lotteries based on the above valuations is the

following:
and
and the implied preference ordering of LB lotteries is:
and .
In terms of rankings, the pricing of the lotteries implies a ranking of “321” and
“321”, i.e. a ranking of risk aversion across the board. This finding is in line with
the risk aversion assumption confirmed in the rankings section, where the
majority of the subjects ranked the safer lotteries higher than the riskier
lotteries. As a result, we report no preference reversals in terms of risk aversion
between the rankings and the pricing tasks.
6.3.2 Sequential WTP
This section presents the findings of the sequential pricing task sections of the
questionnaire. The sequential equivalence method is used to confirm that the
revealed WTP was indeed the subjects’ maximum propensity to risk for the
various lotteries. Following a set of up to five framed questions, the cumulative
amount SWTP that subjects ended up paying for each of the lotteries is presented
in Appendix C, Table C-7. While the overall changes in SWTP are significant
across the lotteries in the bundle, again the source of diversity is driven
primarily off and the certainty effect that it bears. The disparity between
WTP and SWTP calculated in terms of mean values is presented below.
Table 6.7: WTP and SWTP Disparity
Mean WTP €85 €101 €152 €180 €235 €318

Mean SWTP €153 €199 €301 €349 €448 €603
Mean (SWTP- WTP) €68 €98 €149 €169 €213 €285
Mean SWTP / Mean WTP 1,80 1,96 1,98 1,94 1,91 1,90
Mean (SWTP/WTP) 2.00 2.45 3.65 2.87 2.43 2.64
122
where: Mean SWTP- WTP is the mean difference between SWTP and WTP, Mean
SWTP / Mean WTP is the ratio of the Means and Mean (SWTP/WTP) is the Mean
of the SWTP/WTP ratio. The statistical significance of the disparities is
confirmed using Wilcoxon’s Signed Rank test and the results are presented in
Table C-11 and in Table C-14 of Appendix C.
Two key points are worth noting regarding the ratio of the means versus the
mean of the ratios. Firstly, the highest ratios are recorded in the two lotteries
near the equi-probable lottery, i.e. in and in . This is an indication that
preferences are constructed when probabilities are around the 50-50 mark, and
is in line with the assumption that it is difficult to predict the behaviour around
that point. Secondly, a pattern is detected. Both ratios increase sharply and peak
at and decrease thereon until . While the pattern is the same in both the
ratios for lotteries , in a divergence is noted: The decreasing trend
continues for the ratio of the means, but the mean of the ratios picks up. This is a
result of the increased variance in the values assigned to .
The dispersion of amounts increases with the sequential WTP method, as

displayed in the Figure below that presents the Mean and Median WTP vs the
corresponding SWTP values. Their difference is an indication of an
underestimation of WTP prices, which in turn indicates an overestimation of risk
aversion by the subjects. This could be due to miscalculation or cognitive bias, or
it could be a framing effect linked to the construction of preference. While
various assumptions can be made about the reasons why this disparity is
observed, the fact remains that the bid prices on monetary prospects lie below
the true maximum WTP.
123
Figure 6.4: Disparity of WTP vs SWTP
700
600
500
Mean WTP
400
Mean SWTP
300 Median WTP
200 Median SWTP
100
0
L15 L30 L45 L60 L75 L90
In terms of medians, the values are presented in dotted lines in the figure and the
table below. The aforementioned pattern detected in the mean values is not as
consistent for median values, but the median values are not as extreme as the
mean values, indicating that the sample results contain extreme values that
affect the mean.
Figure 6.5: Mean [SWTP/WTP] vs [Mean SWTP/Mean WTP]
3,5
Median (SWTP/WTP) 3
2,5
Median
SWTP/Median WTP 2
Mean SWTP / Mean
1,5
WTP
Mean (SWTP / WTP) 1
0,5
0
L15 L30 L45 L60 L75 L90
Out of the four comparative measures of the figure above, only the Median
(SWTP/WTP) can be statistically tested. Fortunately, its observed values lie very
close to the corresponding mean ratios (which cannot be statistically tested).
124
Table 6.8: Median WTP and SWTP Values per Lottery
Median WTP €50 €50 €100 €150 €190 €250

Median SWTP €83 €115 €172 €208 €325 €500
Median SWTP-Median WTP €33 €65 €72 €58 €135 €250
Median SWTP / Median WTP 1.65 2.30 1.72 1.38 1.71 2.00
Median (SWTP/WTP) 1.10 1.45 1.96 1.78 2.00 2.00
The median SWTP was compared across lotteries using Wilcoxon’s rank-sum
test and statistical significance is not confirmed in direct sequence (for example
between and but is again confirmed between lotteries in increments of
, for example between and . The relevant table is presented in Appendix
C.
The sequential equivalence method involves the incorporation of the stated

WTPs of the initial lottery bundle and frames these lotteries as mixed lotteries,
with each WTP being the maximum loss of the lottery and the maximum gain
being reduced by that amount. Therefore, we can calculate the number of times
the reframed lotteries have received a positive WTP price yields impressive
results, presented in the table below. The higher the number of times a WTP is
re-stated, the more firm the miscalculation of WTP in round one.
Table 6.9: Number of Prices Given per Lottery
No of Total % of
Prices Total
1 26 19 14 14 12 8 93 29.81%
2 6 10 10 6 5 8 45 14.42%
3 6 7 3 10 11 5 42 13.46%
4 2 2 8 7 10 8 37 11.86%
5 12 14 17 15 14 23 95 30.45%
Total 52 52 52 52 52 52 312 100%
For example, Column , Row 2, states the number of respondents who stated a
WTP price in [€10,000, 0.15; €0, 0.85], then stated another non-zero price
for lottery [(€10,000-WTP), 0.15; (€0-WTP), 0.85], and then provided a
price of zero. Also, almost 30% provided 5 prices for each Lottery. The remaining
40% of the subjects provided between 2 and 4 prices for the Lotteries. The
number of times that the respondents provided non-zero prices for each lottery
125
indicates the extent of miscalculation that we might expect in the extraction of

WTP using traditional contingent valuation methodology. It is striking that in
concentrates most of the accurate prices (50% of respondents only provided one
price for the lottery) and is the only lottery where most responses were
repeated 5 times. This is yet another manifestation of the certainty effect, but
also justifies the relatively high disparity between WTP and SWTP in monetary
terms.
The fact that most of the subjects (70%) provided more than one price for each
Lottery produces a contradiction regarding the aforementioned existence of loss
aversion. One might expect that a truthful, knowledgeable statement of the
subjects’ maximum bid price for the initial lotteries in the bundle would lead to a
zero price in the subsequent lotteries. However, subjects not only raise their
cumulative bids, but they do so repeatedly. The amount each subject is willing to
risk to purchase a stake at the desirable payout of the first round is an indication
of each subject’s level of risk aversion. On the other hand, based on the principle
of loss aversion, one might expect that subjects would reject the framed lottery
where a possible loss is introduced. When the lotteries switch from gains-only to
mixed, the principle of loss aversion is faced with a challenge. In this case, it
seems that loss aversion when probability is low has a more profound effect than
when probability is high. This is exhibited in the observation that when a lottery
such as with low probability of a high win is re-framed explicitly stating
potential losses, the attractiveness of that lottery drops dramatically – as
indicated in the few number of times sequential bids occur.
Moreover, upon observing the first row where the number of subjects provided
only one price and did not continue to bid in the reframed lotteries, the riskier
prospect is the only prospect that manages to reach 50% ‘maximum price
reliability’ in terms of WTP.
As indicated in the section above, WTP amounts are consistently increased in

sequential valuation. The mispricing is more profound around the equi-probable
lotteries ( , in line with the assumption that when probability
significance levels are indecisive, i.e. around the 50-50 mark, preferences are not
126
entirely systematic. This observation can be seen as evidence that when

significance is bordering the turning point between significant and insignificant,
preferences are constructed47.
Another interesting point is the consistent difference we observe between Mean

SWTP / Mean WTP and Mean (SWTP/WTP), with individual means yielding a lower
ratios than group means. Similar results regarding the WTA/WTP disparity are reported
in Dubourg et al (1994) on non-fatal road injuries and in Eisenberger and Weber
(1995) who examine both risky and ambiguous task pricing. In contrast, this
phenomenon does not occur when Medians are used instead of Means. The
reason why the pattern observed with Mean values disappears is because of the
existence of extreme values that distort the relevant distributions. These
extreme values have limited impact on Medians.
As a final note, there is no indication of preference reversals between the WTP

and the SWTP implied rankings.
6.4 Valuations through Willingness to Accept
The results of the WTA section are presented in Appendix C, including the
statistical significance results.
A brief comparison with the relevant data drawn from the WTP and the SWTP
sections gives a clear indication of the increase in the dispersion of the prices
between bid and ask values. The significant changes in values in this lottery
bundle are driven primarily from the values of , again indicating a prevailing
certainty effect.
Another key point to note is that WTA indicates a larger percentage of people
approaching risk neutrality (with prices that fall in the “€1,401-€1,500” range).
In fact, we see that in the sample, up to 13.5% of subjects are now risk seekers,
willing to accept more than the expected value of the lotteries to give up their
tickets (row “€1,501+” in the table above). By definition, this is an indication of a
WTA/WTP disparity. This disparity is profound in the comparative analysis that
47An elaborate discussion of the construction of preference is available in Lichtenstein and Slovic
(2006).
127
follows. A comprehensive analysis of the WTA results is included in the section

below, in relation to the WTP and SWTP findings, where interesting observations
are recorded.
6.5 Comparative Analysis of Key Findings
In the table below we present the Contingent Valuation results using mean and
median prices for each of the six Lotteries.
Table 6.10: Summary of Contingent Valuation Means and Medians
Means
Lottery WTP SWTP ⁄ WTA ⁄ ⁄
€85 €153 €68 1.80 €774 €688 9.07 €620 5.04

€101 €199 €99 1.96 €727 €626 7.18 €529 3.66
€152 €301 €149 1.98 €776 €625 5.12 €476 2.58
€180 €349 €169 1.94 €843 €663 4.68 €494 2.42
€235 €448 €213 1.91 €908 €672 3.86 €459 2.02
€318 €603 €285 1.90 €1,072 €754 3.37 €469 1.78
Medians
Lottery WTP SWTP ⁄ WTA ⁄ ⁄
€50 €82.5 €33 1.65 €500 €450 10 €418 6.06

€50 €115 €65 2.30 €500 €450 10 €385 4.35
€100 €171.5 €72 1.72 €550 €450 5.5 €379 3.21
€150 €207.5 €58 1.38 €700 €550 4.67 €493 3.37
€190 €325 €135 1.71 €1,000 €810 5.26 €675 3.08
€250 €500 €250 2.00 €1,000 €750 4 €500 2.00
The WTP column is the mean and median price subjects offered to pay in each of
the 6 win-only Lotteries. This is the price usually obtained in WTP studies. SWTP
is the mean and median cumulative WTP price for each Lottery, extracted until
the prospect is priced at zero.
, and ⁄ .
128
The WTA column lists the mean ask prices for each lottery.
, and ⁄ . These two measures
are directly comparable with similar measurements in prior literature.
and ⁄ essentially
compare the initial measurements with the corrected, cumulative
measurements. The same holds for median estimators.
One important observation is that the ratio of ⁄ is consistently smaller

than ⁄ , indicating a reduction in the observed “endowment effect”, or
“loss aversion”, using sequential equivalence. The fact that SWTP values
approach the WTA values and reduce the effect to almost half that of the WTP
prices is more clearly indicated in the comparative representations of the below
figures.
Figure 6.6: WTA, WTP and SWTP prices
€1,650; 90%
€2,000; 75%
€2,500; 60% Mean SWTP

Mean WTA
€3,350; 45%
Mean WTP
€5,000; 30%
€10,000; 15%
0€ 200 € 400 € 600 € 800 € 1.000 € 1.200 €
The statistical significance of the observed disparities between WTP/SWTP,

WTA/WTP and WTA/SWTP is analysed in Appendix C. The disparity is
significant both in terms of differences and in terms of ratios, and the
significance is not compromised when SWTP is used for the calculations. A
graphical representation of the ratios is presented in the figure below.
129
Figure 6.7: Means and Medians for [WTA/WTP] and [WTA/SWTP] Ratios
12
10
8
Mean WTA/WTP
6 Median WTA/WTP
Mean WTA/SWTP
4 Median WTA/SWTP
0
L15 L30 L45 L60 L75 L90
Regarding the comparison between WTA/WTP vs WTA/SWTP, the disparity is

reduced to almost 50% when SE is applied, extending to a significantly smoother
endowment effect. This disparity is reduced without any changes applied to
WTA. I suspect that the sequential equivalence methodology adapted to WTA
tasks can further reduce this disparity – although this lies beyond the scope of
this thesis. The dramatic reduction in the WTA/WTP through WTA/SWTP
essentially cancels many of the assumptions surrounding the endowment effect
and supports Grether and Plott (1979) in their arguments regarding the
profound impact of methodology on the accurate extraction and interpretation of
behavioural data. The sequential equivalence method basically reveals an
exaggerated, and perhaps miscalculated, endowment effect and corrects this
exaggeration by correcting the approximation of the certainty equivalent
through the substitution of WTP with SWTP.
In terms of standard deviations, they are presented in that follows. Firstly, we

detect a pattern of increasing standard deviation in WTP and in SWTP prices,
and the opposite pattern, a decreasing standard deviation, in WTA prices. In
absolute terms, the riskier lottery exhibits the highest difference between
compensating and equivalence prices, with WTA prices approaching 10x the
equivalence prices. One argument that stems from this observation is that the
standard deviation of WTA is affected by the high payout of (i.e. €10,000),
130
and that the low standard deviation of WTP and SWTP prices is driven by the
low probability of winning in (i.e. 15%). This is in line with the rationale of
Kahneman & Tversky (1979) and of Schoemaker (1989) presented in Tables 1.1
and 1.2 earlier. It basically implies a shift in decision drivers between probability
and payout, triggered by high and low probabilities and high and low payouts,
and a dynamic interaction of probabilities and payouts that often leads to
contradicting preferences and normative violations.
Table 6.11: Standard Deviations of WTP, SWTP and WTA amounts
WTP 101 127 186 195 226 263

SWTP 184 229 313 338 388 391
WTA 1037 698 567 535 446 397
We record no surprises in the approximately double standard deviation values of

SWTP compared to WTP, as the former is a cumulative amount that contains the
latter. A detected pattern is that the dispersion of amounts increases as
probabilities increase, indicating that people are willing to pay more for the
prospect with the lower payout and the higher probability. This pattern also
extends to SWTP, where we find a smoother transition that evens out as we
approach the high probability lottery. However, the reverse is true for the WTA
values. In fact, the standard deviation of the risky prospect ( is 10x higher
than that of WTP and follows a consistent, sharply decreasing trend down to less
than 2x higher for the high probability prospect. In relation to the SWTP values,
the standard deviation at the high probability prospect is almost equal between
SWTP and WTA.
6.5.1 Equiprobable Equivalent
is the equiprobable expected value of each lottery, i.e. the expected value
calculated with the given payouts, but using probability =50%.
is the difference between the equiprobable expected value and the lottery’s
expected value. It indicates the riskiness of the lottery, because it reflects
131
“unlikeliness” in the sense that it measures the distance between the stated
probability of winning the high payout from 50%.
The calculation of the equiprobable values48 of each lottery in the root bundle
are presented in the table that follows. The EQV values are an indication of the
riskiness of each of the lotteries. Negative values are derived for the riskier
prospects and positive values are indicative of the less risky prospects.
Table 6.12: Equiprobable Lotteries
L High Low WTA WTP SWTP

Payout Payout
€10,000 €0 €5,000 -€3,500 €774 -€85 -€153 € 345 €310.5
€5,000 €0 €2,500 -€1,000 €727 -€101 -€199 € 313 €264
€3,350 €0 €1,675 -€175 €776 -€152 -€301 € 312 €237.5
€2,500 €0 €1,250 €250 €843 -€180 -€349 € 332 €247
€2,000 €0 €1,000 €500 €908 -€235 -€448 € 337 €230
€1,650 €0 €825 €675 €1,072 -€318 -€603 € 377 €234.5

Mean €850 -€179 -€342 €336 €254
Observing the data of the root lottery bundle LB, where there are no probable
losses in any of the 6 binary lotteries, a rather conservative compensating pricing
for the lotteries is recorded and prices increase as EQV
approaches 0. For the lotteries prices continue to increase
as EQV decreases.
Assuming that WTA is the equivalent gain of each lottery and SWTP is the
equivalent loss of each lottery, WTA and SWTP amounts are used to derive a
certain amount that bears the same amount as a 50-50 chance lottery with the
given payouts. This may be the amount that a decision maker would both accept
to sell his ticket, and pay to play this ticket. The mean equiprobable value of this
lottery bundle is €254. Again, the deviations of from the mean are reduced
compared to the EQ values calculated using WTP values. As a result, through the
48 Using Equation (25),
132
EQ methodology we confirm the hypothesis that the disparity between WTA and
WTP is significantly reduced using SWTP values.
6.5.2 Group vs Individual Means and Medians
As Horowitz and McConnell (2002) report, a comparison of results using

individual means and group means based on the studies of Dubourg et al (1994)
and in Eisenberger and Weber (1995) show that:
∑
∑
∑
Upon examination of the relationship between group and individual means and
medians, presented in Table below, the importance of the approach adopted in
the analysis is highlighted in the exceptionally large disparity between the Mean
ratios and the ratios of the Means.
Table 6.13: Comparison of Group Ratio Means vs Individual Ratio Means
Means (using WTP) Medians (using WTP) Means (using SWTP) Medians (using SWTP)
26.51 9.07 7.33 10 16.05 5.04 4.08 6.06

17.89 7.18 7.08 10 11.83 3.66 3.17 4.35
17.38 5.12 5 5.5 5.23 2.58 2.5 3.21
12.88 4.68 5 4.67 4.43 2.42 2.76 3.37
8.04 3.86 5 5.26 3.53 2.02 2.5 3.08
7.36 3.36 4.75 4 3.27 1.77 1.94 2.00
∑
Using to represent ∑ and to represent ∑
,
this sample yields the same results as indicated in literature. When comparing
the results with the ratios of WTA/SWTP prices, we notice that mean ratios for
the sequential valuation prices also follow the above pattern. This is due to the
impact of outliers and exceptionally high prices and price differences in the
sample, which substantially affects the means. This problem is overcome using
133
medians. With median ratios the picture is mixed: are higher than
ratios in some lotteries and lower in others, so no conclusive
indications there. When using SWTP prices, however, we observe that
are consistently higher than . The differences in the
ratios are statistically significant across the board, as indicated in Appendix C.

The validity of the data on observations and calculation of the endowment effect
is, by extension, significantly affected by the choice of measure used for the
measurement of the disparity. In this thesis, the most reliable measure is the
Ratio of the Medians, because of the aforementioned presence of extreme values,
the relatively small sample size and the suitability of using individual instead of
group measurements for statistical analysis.
6.5.3 Risk Appetite
By definition the WTP amount stated by the subjects was supposed to be the
maximum amount they were willing to pay to participate in each lottery. As this
amount was the “maximum” we would expect that upon presenting the lottery
with that amount subtracted from both the best and the worst outcome, subjects
would - at best - state a willingness to play the lottery only if it was offered to
them for free. In fact, any assumption about the effect of loss aversion would lead
to the hypothesis that this reframed lottery, which has become mixed, would
bear an analogically greater reduction in utility than its reduction in EV. When
analysed from that perspective, one might say that the fact that subjects offer a
non-zero, positive bid for the reframed lotteries is an indication of the absence of
loss aversion. However, upon closer examination, the picture is very different.
With each WTP, the EV of each lottery decreases by the WTP amount. This
reduction in EV must be taken into account, and this is easily achieved through
the CEFs. In the table below we present the sequential WTP prices paid for each
lottery and the corresponding CEFs.
These prices are presented in the table below. Each lottery row contains the
Lottery’s initial EV per round, the mean WTP per round labelled ( , the
134
corresponding CEF per round, produced using and the change in
CEF from one round to the next, labelled .
Table 6.14: Prices per Round and Corresponding CEFs
Lottery WTP s
EV €1,500 €1,415 €1,389 €1,371 €1,356
€85 €26 €18 €14 €10 €153
CEF 5.69% 1.83% 1.32% 1.05% 0.70% 10.23%
-67.84% -27.87% -20.45% -33.33%
EV €1,500 €1,399 €1,362 €1,338 €1,317
Mean €101 €37 €24 €21 €15 €199
CEF 6.75% 2.62% 1.76% 1.60% 1.18% 13.25%
-61.19% -32.82% -9.09% -26.26%
EV €1,500 €1,348 €1,293 €1,256 €1,217
Mean €152 €55 €37 €39 €18 €301
CEF 10.12% 4.11% 2.85% 3.11% 1.45% 20.04%
-59.39% -30.66% +9.12% -53.38%
EV €1,500 €1,320 €1,246 €1,203 €1,168
Mean €180 €74 €43 €35 €16 €349
CEF 11.99% 5.59% 3.48% 2.94% 1.40% 23.25%
-53.38% -37.75% -15.52% -52.38%
EV €1,500 €1,265 €1,160 €1,107 €1,074
Mean €235 €104 €53 €34 €22 €448
CEF 15.69% 8.25% 4.56% 3.03% 2.08% 29.90%
-47.42% -44.73% -33.55% -31.35%
EV €1,500 €1,182 €1,043 €972 €930
Mean €318 €139 €71 €42 €33 €603
CEF 21.20% 11.74% 6.83% 4.27% 3.58% 40.19%
-44.62% -41.82% -31.35% -16.16%
Mean 11.90% 5.69% 3.47% 2.67% 1.73%
CEF
The last column labelled “Totals” lists the cumulative mean prices paid per
lottery and corresponding CEFs. WTP values obtained in the first round of gains-
only lotteries yield CEFs that range from 5.69% to 21.20%, on average being just
under 12%. When losses are introduced, the CEFs drop to 1.83%-11.74%,
averaging approximately 5.7%.
Moreover, we find that when losses are introduced the drop in CEF is
asymmetrically large compared with the impact of the loss on the EV of the
135
lottery. For instance, in round 2 (WTP1 column) of when the EV of the lottery
drops by -5.6%, the corresponding CEF drops by -67.84%. In fact, this
observation is consistent throughout all the lotteries in the bundle , for which
CEFs drop dramatically.
This observation reveals a valuable opportunity to revisit the principle of loss

aversion under the spectrum of CEFs. The underlining assumption is that loss
aversion lies with the difference in CEFs between WTP and , because in
that difference lies the aversion to negative outcomes which are introduced in
the first round of sequential equivalence, namely . This difference is listed
in the table below. The reason why only is considered in the calculation
and not the rest of the sequential equivalence values ( or the
cumulative SWTP) is that loss aversion sets in when losses are initially
introduced. It lies with the difference in the assigned prices-to-EV ratios of the
gains-only lottery bundle LB and the initial mixed lottery bundle LB’. Subsequent
comparisons, for example between LB’ and LB’’ is a simple comparison of two
mixed lotteries, so leaves no room for the assessment of loss aversion (although,
of course, substantial information on risk appetite can be inferred).
In terms of the SWTA lotteries, the lottery bundle presented was the set of
lotteries of previous sections, minus the SWTP prices. In other words, in this
section the subjects were asked to state the minimum amount they would accept
in order to give up playing the mixed lotteries, comprising the SWTP amounts as
potential losses, with EVs reduced accordingly. As a result, the SWTA prices we
accumulated in this section were expected to be much lower than the loss-free
WTA pricing, and this is confirmed both in terms of prices and CEFs. We present
the WTA and SWTA values, labeled and respectively in the table
that follows.
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Table 6.15: WTA and SWTA CEFs
[ +|
Max
Max
Measure WTA Measure SWTA +|Max Loss|]-
Loss
Loss| Mean
EV €1,500 EV €1,347
Mean €774 Mean €376 -€153 €529 €245
CEF 51.58% CEF 27.91%
EV €1,500 EV €1,301
Mean €727 Mean €402 -€199 €601 €126
CEF 49.49% CEF 30.87%
EV €1,500 EV €1,199
Mean €776 Mean €381 -€301 €682 €94
CEF 51.76% CEF 31.74%
EV €1,500 EV €1,151
Mean €843 Mean €402 -€349 €751 €92
CEF 56.17% CEF 34.80%
EV €1,500 EV €1,052
Mean €908 Mean €442 -€448 €890 €18
CEF 60.51% CEF 42.06%
EV €1,500 EV €897
Mean €1,072 Mean €474 -€603 €1,077 -€5
CEF 71.44% CEF 52.83%
In column “ +|Max Loss|”, the maximum loss of the corresponding lottery in

absolute terms, i.e. the corresponding SWTP price, is added to the mean WTA
price. This amount is essentially the maximum amount at risk from each lottery.
is the compensation amount required to give up each lottery, and the Max
Loss column is the SWTP amount that is now presented as the loss scenario in
each lottery49. The result of this addition should be very near WTA prices, and
the resulting values presented in the last column “[ +|Max Loss|]-Mean
are very close. In fact, they converge almost entirely as
probabilities of winning increase, i.e. in and in . If we consider this
exercise a test for the validity of the data, this test basically confirms the validity
of the SWTP values, which is impressive in the high-probability lotteries.
49This refers to the average values for SWTP and SWTA lotteries, which means that, for example,
is the lottery [€9,847, 15%; -€153, 85%] and the average price subjects asked to give up
this lottery was €376. These are average amounts, the actual lottery values were formulated
through a macro-enabled spreadsheet according to the subjects’ previous responses.
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Upon testing the equality between the WTA values and the WTA+|Max Loss|
values and the null hypothesis of equality was not rejected (the corresponding p-
values are presented in Appendix C), confirming no statistical significance for the
disparity.
Finally, the CEFs for WTA and SWTA prices are calculated. The former are the
compensation prices stated for Lottery bundle and the latter are the
compensation prices of a synthetic bundle comprising the lotteries in minus
the corresponding SWTP values, i.e. including maximum potential losses.
6.6 Implications of Key Findings
6.6.1 The Asymmetric Significance of Amounts
In Chapter 450 we referred to Kahneman and Riepe’s (1998) observation that

people find a 1% chance to win €1,000 more attractive than a €10 gift. Their
explanation for the phenomenon is the tendency to underweight remote
probabilities.
One might suggest that another reason for this sort of behaviour is the
asymmetric significance of amounts. In simple notation, the preference
relationship described here is . In the absence
of reference dependence, it is difficult to explain why anyone would turn down a
sure gain for a 1% chance of winning the uncertain equivalent. Through the
introduction of reference relativity, however, one can also assume that this
simple decision is recoded as:
“1% chance to win a significant amount vs.

100% chance to receive a very insignificant amount”
While the uncertain prospect bears very little significance in terms of probability,
it offers the remote chance at a significant amount. The certain prospect is
multiple times less significant in terms of payout. Reference dependence allows
for this sort of asymmetric perception of payouts, although not explicitly.
50 Section 4.3.1
138
Barberis et al. (2006) consider a decision maker who rejects a favourable gamble
of Rabin’s (2000) paradox. This violation of rationality by EUT standards is also
considered as an exhibition of loss aversion by PT and other reference-
dependent theories. I bring forward an assumption surrounding loss aversion
that might explain such behaviour and incorporates the asymmetric significance
of amounts.
Extending Rabin’s lottery of Equation (21) using significance levels, I can now
offer a behavioural explanation for the paradox. Drawing from the data of Table
6.2, for the 38% of the subjects who stated that €100 is a “Very insignificant”
gain and that -€100 is an “Insignificant” loss, essentially Rabin’s lottery
becomes:
The decision maker could be very rich, with a high net worth of several million
euros, or very poor, still the labelling of the amount is entirely subjective. It is
essentially a matter of disposition, as well as status quo. Disposition can be
simplified to reflect risk aversion, and the status quo can be simplified to reflect
current wealth.
I propose that over and beyond the decision makers’ reaction to anticipated
gains or losses, in the editing phase of prospect evaluation another significant
transformation takes place: The ranking of amounts by subjective order of
significance, which leads to an asymmetric categorization of gains and losses.
This new approach that I suggest in this thesis is consistent with reference
dependence and the basic principle of Kahneman and Tversky’s loss aversion,
but instead of assuming that the aversion impact is triggered by the gains versus
the losses domain, the assumption is that this trigger lies with the asymmetric
subjective significance of the amounts in both the gains and the losses domain.
A hypothetical form for this asymmetry is presented in the figure that follows.
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Figure 6.8: An Asymmetric Significance of Amounts
Probability
Certainty
Despair Euphoria
High
Medium
Low
Losses Gains
Indifference
Payout
0
Significant/ Not Very Very Not Very Significant/
Very Significant Significant / Insignificant Significant/ Very Significant
Insignificant Amount Insignificant
The gains and losses domains for payouts refer to departures from the reference
point 0. The specified ranges referring to the significance of the amounts are an
assumption on the subjective value each range of amounts bears based on the
data presented in section 6.1. In the gains domain, the range of amounts that are
characterized as “very insignificant” is wider than the corresponding range in the
losses domain. As a result, a gain of €3,000 is considered “Insignificant”, and a
loss of -€3,000 is considered “Not Significant / Not Insignificant”.
The range of very insignificant and not very significant amounts for gains is
considerably smaller than the corresponding ranges for losses. The assumption
is that a gain of €100 bears less importance for the decision maker than a loss of
€100, in line with Kahneman and Tversky’s assumption (1979). The difference in
the representation in traditional loss aversion definitions is not due to the fact
that one is a gain and the other a loss, but rather due to the fact that the range of
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significant gains may be the range of [€S, €10S] and the range of significant
losses may be the range [ and -€S may well be a very significant loss
for the decision maker.
Our understanding on the role of the asymmetric significance of the amount also
creates further implications for the way subjects perceive the entire lottery
game. For example, moving upwards in terms of probability, subjects faced with
very significant losses will feel despair and will pay what they can to avoid taking
the prospect, and subjects faced with very significant gains will feel euphoria and
will pay what they can to acquire the prospect.
Three key assumptions are drawn from the above statement:
Firstly, that subjects in both cases will exhaust their available resources to avoid
(in the case of losses) or acquire (in the case of gains) the prospect, which means
that their bid is directly relevant to their cash wealth rather than any preference.
Secondly, that the amount a subject is willing to pay in the very significant
amount/very high probability domains of both gains and losses may be very
similar.
Thirdly, amounts that are very significant to a subject by definition lie well above
the current cash resources of the subject. As a result, the amount the subject is
willing to pay may be well below the Expected Value of the lottery, not because
of risk aversion, but rather due to limited resources.
Furthermore, as many prior studies in the field have used prospects featuring
very insignificant gains and losses, the impact of the asymmetric significance of
amounts was understated. This assumption is based on the observation that
significance becomes symmetrical as amounts reduce to very insignificant
(approaching zero) and as amounts increase to extremely significant. On the
other hand, extremely significant amounts are amounts above a certain level
which might be higher for gains than for losses, but which eventually reaches a
maximum for both gains and losses due to the diminishing marginal utility of
money.
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The same disproportionate assessment has already been documented for the
evaluation of probabilities (eg. Slovic and Lichtenstein, 1968; Shepard, 1964),
and is a fundamental assumption of Prospect Theory. For example, for the
natural optimist, a 30% chance for a win is upgraded from “possible” to
“probable” or even “near certain”. For the pessimist that 30% chance is
downgraded from “possible” to “unlikely” or even “almost impossible”.
Combined with the significance of the corresponding outcome, the probability
bears a “variable” or “subjective” dimension that is often underestimated or
exaggerated. For instance, a 30% chance to win €1,000,000 is disproportionately
high compared to the 30% chance to win €1. Similarly, a 30% chance to lose -€1
seems quite low and not a prospect one would be particularly adverse towards.
A 30% chance to lose -€100,000 seems “high”. Such considerations, however, lie
beyond the scope of this research, and perhaps beyond the scope of economics
and finance in theoretical terms.
6.6.2 Inflated Risk Aversion & Loss Aversion
The observed disparity of WTP and SWTP indicates that the amounts decision
makers are willing to risk to obtain a lottery ticket is higher than the amount
they initially estimate as their maximum WTP. The theoretical implication of this
observation is an inflated risk aversion. In practical terms, this finding reveals
the importance of framing on decision making and the profound effects of
miscalculation even among this group of financially literate professionals with
investment experience and familiarity with the concepts of probabilities and
returns. On one occasion, a subject used a calculator and performed numerous
calculations to specify his WTP and his WTP’, and still ended up paying for the
same lottery, 32% more than initially anticipated.
Perhaps more importantly, an inflated WTA/WTP disparity that, as mentioned

above, is affected by an undervalued WTP is, in my view, further inflated by an
over-stated WTA. As a result, theories built on the assumption of an
unrealistically large WTA/WTP ratio that leads to assumptions of an endowment
effect and other descriptive failures must be revisited.
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As discussed in the early chapters of this thesis, the comparison of

“compensating” and “equivalent” values – i.e. the WTP and WTA prices - is
essentially a comparison of the value of a risky prospect from a different
perspective: WTP is a “price tag” for the potential loss and WTA is a “price tag”
for the potential gain. Hence the perspective of Gachter et al (2010), who use
WTA/WTP to estimate loss aversion. No doubt the WTA/WTP disparity is a
convenient, albeit unrefined, tool to test the existence of loss aversion. However,
it provides a rough estimation of its magnitude. Indeed the series of reports that
document an “endowment effect” based solely on evidence of the WTA/WTP
disparity have placed unreasonable faith on the accuracy of both factors of this
ratio. In fact, what this ratio represents is an approximation of the certainty
equivalent from “the left” and from “the right” (or from the top and from the
bottom, in the perspective of the figure below.
Figure 6.9: WTA and WTP Approximation of the Certainty Equivalent
WTA = CE + Income Effect + Loss Aversion

Amount
CE
WTP = CE – Risk Discount

Factor
When compared to what these two values, WTA and WTP, truly represent, ie. the
certainty equivalent, WTP is lower and WTA is higher than the true certainty
equivalent price, i.e. the price that makes the decision maker indifferent towards
taking the uncertain prospect. In a way, it is an unavoidable disparity that
compares two “biased” values.
Using Framing to Correct WTA/WTP
In this thesis the sequential equivalence methodology attempts to reduce the

distance between the WTP and WTA values and the CE. This distance is
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augmented by the overestimated risk aversion implied in WTP values, driven by

the decision makers’ truthful, yet miscalculated estimate of their propensity to
risk. The empirical justification of this assumption is provided in this thesis, for
instance in the reported results that show that the reintroduction and reframing
the prospect yields a sequential WTP that is higher than the initially stated price
in 70% of the subjects. The sequential equivalence method allows for a better
approximation of the true amount subjects are willing to risk to purchase the
lottery. This amount approximates WTA and reduces the ratio, leading to a lower
endowment effect. The sequential equivalence methodology can be applied to
extract and correct WTA values, further reducing the disparity. The extension of
the sequential equivalence methodology to WTA may result in a sequential
WTA/WTP ratio approaching unity; on the other hand it will probably still
contain biases driven from the difference in perspective from which WTA and
WTP approach the certainty equivalent. I propose a more efficient
approximation of loss aversion, which lies with the direct comparison of
compensating prices for gains-only vs compensating prices for mixed prospects,
through the sequential equivalence method.
Comparing WTP in gains-only vs mixed lotteries
As discussed earlier the methodology applied for the extraction of WTP provided
prices for each of the lotteries in the initial lottery bundle LB, which contained
gain-only lotteries, and then provided prices for each of the mixed lotteries in the
mixed lottery bundle LB’. This allows for a direct comparison of WTP in the
gains-only lottery and of the WTP in the subsequent mixed lottery. While it
would be very convenient to just compare the two WTP values, in fact that would
be a mistake, as these two values are assigned to lotteries with different EVs.
What should actually be compared are the WTP of the gains only lottery and the
WTP of the mixed lottery, relative to their respective expected values. In the
dataset, this difference in EVs increases as the probability to win increases. In
order to take this difference in EVs into account, I compare the CEFs instead of
the WTPs. This transforms WTP into EV-adjusted percentages, which describe
the fraction of the expected returns that subjects are willing to risk to play the
lottery. The fact that this percentage is higher for gains-only lotteries than for
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mixed lotteries is the indication of loss aversion. In fact, looking at subsequent

bids in the sequence, the CEFs across all mixed lotteries exhibit smooth
fluctuations which, compared with the substantial decrease observed between
the gains-only and the mixed lotteries, are relatively insignificant. This dramatic
drop is statistically significant across all Lotteries in LB, with p-values<0.0005
using the Wilcoxon Signed Rank test.
We believe that loss aversion can be used as a component of risk aversion. More
specifically, it is implied in the ratio of CEF values, using the WTP amounts before
and after losses. This measure is a Loss Adjusted Risk Aversion Coefficient,
defined as:
{ (43)
Further calculations reveal the breakdown of LARA into its key components, as
indicated below:
(44)
So when there is a non zero bid for the mixed prospect, the LARA coefficient
becomes:
(45)
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The two definitive components of LARA are: and . The first ratio, ,
reflects the relationship between the price paid for a gains-only lottery and the
price paid for the mixed lottery. A rational decision maker is expected to have a
. The reason is that the event of is a violation of rationality as
the decision maker would be paying more for a lottery with a lower expected
value. After all, because . Obviously, if then the
decision maker is not sensitive to losses and pays the same amount for two
lotteries with a different EV. For the risk neutral decision maker whose
approaches 1, any diversion from risk neutrality when losses are introduced can
be attributed to loss aversion.
So basically the ratio of the WTP values measures the impact of the introduction
of losses on the bid price. But this measure cannot, in itself, be the loss aversion
coefficient, because it is contingent upon the EVs of the lotteries that the two
prices refer to. To that effect, the second factor, or , is critical and its
contribution is the measurement of risk aversion. When risk

neutrality is exhibited as the propensity to pay the lottery’s EV to buy the ticket.
When risk aversion prevails, which is the case with 100% of the
subjects in this sample and when then the decision makers are risk
seekers. Given risk aversion, ( )
Obviously, the indication for the existence of loss aversion and a prerequisite for
the estimation of this adjustment factor is a non-zero which essentially
translates to a non-zero . The LARA coefficient for the measurement of loss

aversion can be applied to datasets featuring sequential equivalence, or it can
simply be used to compare the WTPs of two independent lottery bundles, for
instance between a mixed and a gains-only prospect, or between a mixed and a
loss-only prospect. The flexibility of the index lies with the fact that it depends on
two amounts, namely the expected value of the lottery and the bid price. The
former is objective and implicit to the prospect; the latter is subjective and
explicitly defined by the decision maker.
146
The behaviour of this coefficient is summarized in the table that follows.
Table 6.16: Factor Interaction of Loss-Adjusted Risk Appetite (LARA)
Risk Appetite Risk Averse Risk Neutral Risk Seeking
>1 >1 >1

Factor
>0 =0 <0
The implied loss aversions calculated using from the dataset

discussed in this study are presented in the table below.
Table 6.17: Loss Aversion Implied in CEFs
Lottery Implied Loss

Aversion
5.69% 1.83% 3.11
6.75% 2.62% 2.58
10.12% 4.11% 2.46
11.99% 5.59% 2.14
15.69% 8.25% 1.90
21.20% 11.74% 1.81
6.6.3 Further Implications Drawn From Current Findings
The revealed perception of risk implied in the rankings and valuation tasks in the
dataset leads to the extraction of a set of assumptions which link the significance
of the payout with the probability and, by extension, with perceived risk
aversion. Without considering the functional form of the utility function or other
parametric assumptions, I believe that revealed preference is a comprehensive
indicator of risk aversion and loss aversion, given the subjective significance of
amounts.
In the gains domain, the perception of risk pertains to the risk of not winning.
From that perspective, risk is quantifiable and can be measured as an
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opportunity cost. In this thesis I have documented the relationship between

payouts and risk appetite. While actual risk is based on probabilities, perceived
risk is linked to the payouts and it is indeed perceived risk that determines risk
appetite. I have shown that people overestimate their risk aversion and
underestimate their maximum willingness to pay (exhibited, for instance, in the
disparity between SWTP and WTP). A hypothetical interaction between the
subjective significance of payouts and risk appetite is presented in the table
below. Perceived risk is represented in the Probability column, and the resulting
risk aversion is presented in the relevant columns for gains and losses. “Risk
Aversion” is considered equivalent to “Perceived Risk” on the assumption that it
is the subjective assessment of risk that exhibits itself as risk aversion.
Table 6.18: The Significance of the Payouts and Perceived Risk
Risk Aversion Risk Aversion

Amount Significance Probability
(Gains) (Losses)
Low High High
Very Significant Moderate High High
High High High
Low High High
Significant Moderate Moderate High
High Moderate High
Low High Moderate
Not Significant and Not
Moderate Moderate Moderate/High
Insignificant
High Low High
Low Moderate Low
Insignificant Moderate Moderate Moderate
High Low Moderate
Low Low Low
Very Insignificant Moderate Low Low
High Low Low
Risk aversion when dealing with gains is driven by the risk of an opportunity
cost. When losses are introduced, preference and choice are driven by the
interaction between the probability of the payout and the level of the payout
which determine the overall attractiveness of the prospect. The impact of the
asymmetric significance of amounts on the perception of risk is reflected in the
increased risk aversion in the loss domain (due to loss aversion) when compared
to the gains domain. Coupled with the distribution in ranges of significance
between gains and losses indicated earlier in Figure 6.8
148
Figure , these asymmetries are further enhanced and may well be a definitive
characteristic of the construction of preference among risky prospects. Further
research may indicate that modelling this asymmetry can improve both the
predictive and the descriptive conformity of theoretical assumptions, within or
beyond the axiomatic framework of EU.
Finally, the confirmed asymmetries of preferences indicate that the impact of

perceived prospect risk on the reference point is catalytic. When the probability
of an event is high, even to the point of approaching certainty, reference points
must incorporate the probable event, or a reduced version of the probable event
to reflect the true starting point of the decision maker. The reason for this
assumption is that a significant probability to win a positive amount is
mistakenly overstated as a near certain event, and failure to win that amount is
subsequently experienced as a loss, albeit an opportunity lost. Taken from that
perspective, loss aversion drives some risk aversion when stakes are high.
When perceived risk is low, the sample produces no evidence of status quo
adjustments towards an accurate reference point. Any surprising win shall be a
gain that adds to the decision maker’s net worth, and vice versa for losses. The
generally relaxed viewpoint that the subject has when stakes are low reduces
bias and risk aversion, and one may find that risk seeking and risk neutrality are
more common. I believe that the primary reason for this is the low opportunity
cost attached to any decision, which reduces any regret effects.
When perceived risk is moderate, the reference point departs from status quo
according to the subjects’ weighting of probabilities. This is perhaps the reason
why preferences around the equiprobable point (i.e. the lottery that gives a 50%
chance for either outcome) tend to have increased volatility and dispersion.
When there is no solid expectation about the outcome of the lottery, as is the
case when the two outcomes are perceived to be equally likely, the reference
point may shift either way, based on biases and heuristics that, in my opinion,
cannot be predicted by economic or decision theory.
149
Chapter 7 Conclusion
Chapter 7 - Conclusion
The objective of this thesis was to provide an analysis of revealed and stated
preferences facing risk, a pursuit inspired by the works of Kahneman, Tversky
and Knetsch, who used experimental data to reveal the descriptive weaknesses
of “hard science”, and by empirical methodologies regarding Rabin’s paradox.
Upon reviewing existing literature, however, we were surprised to see that often,
research within the tight framework of theory does not only suffer from
axiomatic deviations, but also from a profound departure from good, old-
fashioned common sense. In contrast, I believe that this thesis offers a practical,
reasonable and realistic non-parametric approach to the analysis of preferences
among risky prospects.
My approach was based on empirical data collected through a questionnaire

comprising monetary gambles, with real and hypothetical payouts. Choice
decisions were recorded in two modes, mirroring PTs editing and evaluation
phases, where subjects were asked to characterize and rank prospects (editing),
and then price prospects (evaluation), revealing their preferences. I kept the
goals simple to promote accuracy and carefully chose a sample of professional
investors to maximize understanding and cognitive ability, specifically in relation
to probability and risky returns.
The findings that arise from the data and the extensions of the data exceeded our
expectations in terms of consistency. There is a profound preference for more
risk when gains were insignificant, gradually moving towards increasing risk
aversion when the subjective significance, or “importance” of gains increases.
People were clearly happy to exchange very large potential gains to get closer –
probability wise - to winning, when amounts increased beyond their personal
“significant” threshold level. They were equally comfortable with the
opportunity cost of not winning anything, when payouts decreased to very
insignificant.
150
In terms of self-determination and perception of subjective significance, I record

a striking asymmetry between perceived significance of amounts offered as gains
and the perceived significance of these same amounts offered as losses. This
asymmetry reveals a dimension of loss aversion that relates to the magnitude of
the gain and loss, and not the absolute magnitude of the amount. In itself, this
manifestation of loss aversion can successfully explain Rabin’s paradox.
Similarly, the profound underestimation of propensity to risk was documented

in the striking difference between WTP and SWTP. The disparity between the
initial price and the cumulative price subjects in the sample paid for a stake in
each of the lotteries was substantial, on average twice their initial price. This
effect was more profound among the safer lotteries.
Another key finding is the presence of an inflated endowment effect. A critical

comparison was considered: the equivalence of a certain gain with an uncertain
gain (WTA) and the equivalence of a uncertain loss with an uncertain gain
(WTP). Depending on the perspective one wants to adopt, the significance of an
uncertain loss reaches the significance of a much higher uncertain gain. This
documents the theoretical impact of significance asymmetries in decision making
when faced with monetary prospects. Future research can extend these
principles to other combinations of equivalence, and incorporate these findings
in a coherent theoretical model.
Moreover, in terms of traditional evidence, I confirm the existence of a

persistent, consistent disparity between WTA and WTP. However, I find that
WTP in experimental settings tend to be underestimated, indicating an
exaggerated revealed risk aversion which, however, does not correspond to the
true propensity to risk, which is higher. I suspect that the same could be true for
WTA, which may be an overestimated WTA which in sequential terms could
prove to be lower than initially stated, further reducing the disparity. The
endowment effect, at least in monetary prospects, may be inflated by
misperception, self-inflicted bias or plain miscalculations and suggest that the
sequential equivalence method is applied extensively and in variation to include
Sequential Willingness to Accept alongside SWTP before I conclude as to the
151
existence of any endowment effect in the absence of attribute bias (as is the case
when payouts are monetary).
Last, but not least, our findings allow us to be sceptical about the validity of the
assumption that the WTA/WTP disparity is evidence of an endowment effect.
Evidence of miscalculation, based on the aforementioned overestimated risk
aversion, indicate substantial understatement in WTP in experimental settings.
Further research can extend to examine the assumption that the opposite holds
for the WTA, i.e. that WTA prices are unrealistically inflated and that in real
conditions a “deal” could be done at lower price levels than those stated. If this
hypothesis is accepted, the sequential equivalence methodology would bring the
WTA/WTP disparity near normatively acceptable levels.
This does not imply that I propose the dismissal the concept of loss aversion. On
the contrary, evidence of loss aversion in the WTP/SWTP disparity which, when
compared to the EV of the prospect, provides an accurate approximation of the
adjustment that is required in the analysis of prospects that involve gains only,
and of prospects that involve mixed outcomes of both gains and losses. This
adjustment factor is essentially a measure of loss aversion, based on the CEFs.
Overall, throughout this analysis I have assumed probabilities to be known and

explicitly determined. The subjective significance of probability, however, no
doubt also bears great impact on decision making. This aspect has been amply
analyzed in reference-dependent theories and the transformation of
probabilities in decision weights. I abide by these considerations and shall leave
the perception of probability as a key point for future research, relative to the
significance of amounts.
7.1 Future Studies in the Analysis of Risk Preference
The sequential equivalent method uses the framing effect to extract true
willingness to pay. The data in my sample indicates that most subjects raised
their bids when faced with sequential pricing tasks. I expect in the future to
apply the sequential pricing method to WTA prices and examine the impact of
152
the corrected values on the WTA/WTP disparity. In that context, I predict further
reductions in the endowment effect.
One rather obvious direction I leave unexplored is the importance of the

asymmetric significance of amounts when dealing with loss-only prospects.
Building on consumer theory where a significant distinction in the analysis of
preference is the distinction between a ‘want’ and a ‘need’, can be likened to the
behaviour of decision makers when faced with very significant amounts as
responding to a “need”, translated into euphoria and despair. The former
indicates that the subject will pay whatever he can to play the lottery, and the
latter indicates that the subject will pay whatever he can to avoid playing the
lottery. This resembles the distinction between the need for money and the want
for money. When payouts are very significant, winning the payout will have a
long term impact on the lifestyle of the decision maker, the desire to win the
payout is very strong, but the win is still optional. When payouts are very
significant, but negative, i.e. very large potential losses, the aversion to the
prospect is very strong and can indeed be compared to the strength of a need, i.e.
the need to avoid the risk of the potential loss. This exhibition of loss aversion
and similar considerations about the strength of desire or aversion in the face of
extreme payouts is a significant point for future research.
7.2 Future Studies in the Analysis of Probability
The analysis of the perception of probability has largely, and deliberately, been
neglected in this analysis. While Kahneman and Tversky’s (1979) adaptation of
probability through decision weights is very interesting, I propose that the
impact of the asymmetric significance of amounts on probability is incorporated
in the calculation of any transformation of probability.
Evidence of such asymmetries has been observed in experimental settings and

reported in prior literature. However, the sort of analysis I would like to see
spreads beyond the simple realization that probabilities can be distorted. We
refer to the analysis of the impact of the significance of amounts on the
subjective assessment of probability. To illustrate, consider the following
example: A prospect offers a 25% chance to win €2, else win nothing. Most
153
people would be indifferent towards the prospect, and would consider winning
the (relatively insignificant) amount of €2 possible, but not probable. Most
people would say that 25% is a low probability and that winning €2 is unlikely.
Now consider surgery which gives a 25% probability of death. 25% may now
seem painfully probable.
This sort of interaction between the perception of probability and the level of the
payout is what I have in mind, and I believe that the assumption of independence
is entirely unrealistic without some adjustment for the interaction of probability
and significance of potential outcomes (in line with Diamond, 1988).
Moreover, while it is easy to distinguish biases and heuristics as the cause of

diversion from normative theory, reference dependence can extend to the
significance of probability. For instance, suppose a decision maker is faced with a
prospect that offers a 90% chance to win €1,000. For the optimistic decision
maker, should this amount not be incorporated in current wealth, altering his
reference point? Is this decision maker not more likely to experience regret than
when faced with moderately likely prospects? It will be very interesting indeed
to examine the incorporation of future outcomes in current reference points.
Similarly, our analysis focused on risky prospects, with given probabilities, and,
as such, ambiguity was deliberately not considered. One different path that might
lead to significant insight has to do with uncertainty, rather than risk. When
probabilities are not explicitly defined, but rather assumed or calculated or
inferred by the decision maker, a key point to consider is the level of confidence
that the decision maker places on this estimation of probability. The analysis did
very little in the direction of ambiguous prospects, but I believe that the
evaluation of a prospect for which a probability is given is very different from the
evaluation of a prospect for which the probability is assumed by the decision
maker. I am not referring here to ambiguity aversion, a well-known and widely
documented phenomenon introduced by Ellsberg’s paradox (1961) but I refer to
the confidence with which an assumed probability bears the same degree of
uncertainty as a given probability. This is exemplified using a simple comparison
between a risky prospect and an ambiguous prospect, as follows:
154
The chance to roll 5 when rolling a fair die is 1 in 6, or 16.67%. The outcome of
the roll is uncertain, but we know for a fact the probability of a 5. The confidence
placed on that fact is 100% (assuming the die is fair and excluding any impact of
natural phenomena that might affect that probability). Now let’s consider the
shares of a company that historically pays no dividends and an investor who
foresees capital gains and the opportunity to make a profit from an imminent
increase in the share price. One assumption may be that an investor who decides
to purchase the stock assigns at least 51%51 probability to a stock appreciation.
One might even assume that the more conservative the investor is, the higher the
probability he/she would need to assign to a potential stock increase. A very
conservative investor would perhaps require an assumed 80% probability for a
stock price increase. The question is, would a very conservative investor ever
assume an 80% probability in the face of ambiguity? And if he did assume such a
high probability, how can one be certain that a likelihood of 80% does not bear
the significance of 90% or more for this investor? The question, of course, is
rhetoric, given its philosophical and psychological complexity, but still worth
pursuing in research.
7.3 Concluding Remarks
I embarked on a long and difficult journey to examine the formulation of

preferences among risky prospects, inspired by the profound volatility of
preferences that derivatives market investors exhibited in their trading patterns.
The consistent and profound tendency to “raise the bids” in sequence, rather
than in lump sums, formed the basis for the development of the sequential
equivalence methodology.
The decision to avoid attempting to justify investor beliefs was, I believe, a wise
one. Why an investor believes a stock will rise, and how much confidence he
should place in this belief for it to materialize into a trade, is the result of what I
believe to be a very long list of factors, many of which are unknown,
51Assuming no dividends. If the stock paid dividends, the investor would accordingly adjust the
probability of a price increase to a lower level, assuming the additional benefit of a dividend.
155
unpredictable or subjective. This led to the decision to simplify the task and
examine financial behaviour facing risk, with the probability as a given.
The result is the analysis that concludes here. I believe that my contribution
provides insight into the perception of financial risky prospects. In both practical
terms and theoretical terms, the sequential equivalence methodology exposes
the compelling impact of research methods and experimental design. It shows
that biases and deviations from normative predictions may, in fact, be smaller
than existing research suggests. My proposition for a Loss-Adjusted Risk
Aversion coefficient incorporates reference-dependence. Finally, the asymmetric
significance of amounts proves that subjectivity is an inherent component of
risky decisions, and a “horizontal” approach to modeling behaviour will suffer
from descriptive violations because of it.
156
Appendix A - Beliefs
The behavioural finance school according to Barberis and Thaler (2005) deals
with two main issues: limits to arbitrage and investor psychology. Both pillars of
scientific research are rich in empirical observations that inspire and support
alternative approaches to the expected utility assumption. With regards to
investor psychology, the construction of beliefs and preferences both lead to
significant violations of normative predictions. Deviations from Bayes’ rule that
lead to violations of EU are summarized below, as an overview for information
purposes but beyond the scope of this research.
Tversky and Kahneman (1986) document the descriptive failure of rational

theory of choice. Their views are supported by financial economists Thaler and
De Bondt, whose work on investor behaviour established the field of behavioural
finance (De Bondt and Thaler, 1985; Thaler, 2005).
Research of investor behaviour has also shown that investors tend to sell
winning investments too soon and to hold on to losing investments too long
(Odean, 1998; 1999; Kumar and Lim, 2008). This observation is attributed to the
disposition effect, the tendency of investors to sell winners instead of losers in
their portfolios. Advances in behavioural finance have, in fact, cast doubt on the
efficiency of markets. Evidence of investor overreaction to shocks (De Bondt
and Thaler, 1985; 1987) formed the basis for the development of a theory of
security markets incorporating investor overconfidence (Daniel et al., 2002).
The same observation was made by Hong and Stein (1999) whose model
incorporates underreaction in the short term and overreaction in the long term.
Along the same lines, Veronessi’s model (1999) predicts overreaction to news
against a trend.
Some of the concepts included in behavioural finance research include market

inefficiencies exhibited in the equity premium puzzle (Benartzi and Thaler,
1995) and the rejection of favourable prospects known as status quo bias
(Barberis and Huang, 2006; Samuelson and Zeckhauser, 1988), which refers to
157
Appendix A Beliefs
an aversion to change. In fact, status quo bias is directly relevant to reference

dependence.
For a comprehensive overview of behavioural finance, please see Shleifer’s

(2000) “Inefficient Markets: An Introduction to Behavioural Finance”, Starmer’s
(2000) work on choice under risk where regret theory is introduced, and
Shefrin’s (2000) “Beyond Greed and Fear”, a book on the investor psychology.
In terms of probability judgment, Kahneman and Frederick (2002) provide a list

of heuristics that lead to misapplication of statistical sampling methods that
standard economic models incorporate. As Camerer and Lowenstein (2004)
note, apart from the fact that Bayesian updating requires a prior and
presupposes the separation of previously evaluated probabilities and evaluation
of new evidence. Cognitive procedures, however, often rely on previous
information in their assessment of prospects, essentially violating this
assumption. The separability assumption also presupposes that probabilities and
corresponding utilities are independently evaluated – Babcock and Loewenstein
(1997) provide some examples of violations of this assumption. Finally, Bayes’
rule assumes that preferences are independent of the order in which the
alternative prospects are presented. Hogarth and Einhorn (1992) show that
“order effects” distort probability judgment and overweight or underweight
information already accessed at various points in time.
Some more biases and heuristics that influence behavior are presented in the
Table below.
158
Appendix A Beliefs
Table A-1: Overview of Observed Biases and Heuristics52
Bias / Heuristic Observation
Self – attribution, People assign high probability to events that actually occur 60% of
hindsight bias – Violation the time (Alpert and Raiffa, 1982). Investors sell profitable
of Bayes’ Rule investments too early and losing investments too late (Odean,
Leading to: 1998; Daniel et al. , 1998). Events that people believe are certain to
Overconfidence occur, actually occur 80% of the time (Fischhoff et al., 1977).
People are often unrealistic regarding their skills and talents

Optimism, Wishful
(Weinstein, 1982) and consistently overestimate their ability to
Thinking
complete tasks in time (Buehler et al., 1994).
Leading to: Unrealistic Optimism and overconfidence lead to excessive business entry
expectations
(Camerer and Lovallo, 1999) and to overtrading (Odean, 1999).
People generalize and assume characteristics of a data set A are
reflected in data set B, in other words they violate Bayes’ law53.
Base rate neglect / People misjudge the likelihood of events by assuming a few
sample-size neglect observations are representative of a true skill, tendency, trend or
momentum (Gilovich et al., 1985). Also known as the “law of small
Leading to:
Representativeness numbers” (Rabin, 2002) where for example if a coin tossed 5 times
has turned up heads, some people will expect the next toss to bring
tails, although the probability for tails is always 50%.
When faced with new information, people tend to underweight
Misapplication of Bayes’
some components, fail to identify others and misinterpret
Law
information.
Leading to: People overweight priors when assessing data (Edwards, 1968;
Conservatism
Thaler, 1980)
Revealed preferences are often different from true preferences, or
Misspecified Values revealed preferences are constructed when faced with a decision
problem.
People often attach an arbitrary value to a prospect and readjust
Leading to:
Anchoring their assessment based on that arbitrary value which becomes an
anchor (Kahneman and Tversky, 1974).
52 Barberis and Thaler (2005)

|
53Bayes’ law states that | , but
observed behavior shows that people consistently overweight p(description|statement B) and
underweight the base rate p(statement B).
159
Appendix B
Appendix B - The Questionnaire
160
Appendix B
Table B-1: Overview of Questionnaire and Layout
Questionnaire No of
Description Objective
Section Questions
A collection of questions containing demographic and personal To determine that the subjects are financially literate
Background
23 information, information on investment activity and familiarity with individuals in a comparable, consistent sample and make
Information
investment products, and some self-assessment questions. reasonable assertions on their expected risk profile.
10 + 4 A set of questions in the form of a Likert scale, asking subjects to To verify that subjects shall not be indifferent towards the
optional characterize various amounts by order of significance, ranging from amounts the questionnaire prospects present later on.
Significance of very significant to very insignificant (5 levels). A short
questio To gradually familiarize the subjects with the layout of the
amounts explanation/definition is provided for each significance level, to avoid
ns on questionnaire, starting with simple currency amounts
(Part 1) misunderstandings.
income (followed by simple probabilities, then probability and payout
levels pairs, etc).
Significance of The same set of questions as above, but with the amounts converted to To compare the perception of amount significance between
amounts 10 losses. Subjects are asked to characterize these loss amounts in the gains and losses. To obtain an indication of the significance
(Part 2) Likert scale. ranges for losses, as compared to gains.
Subjects are asked to assume that they are being offered a set of To indicate risk appetite and document variable risk appetite
prospects to choose from. They rank these prospects in order of contingent upon the payout level.
attractiveness, i.e. state which prospect they would prefer to the
6 Compared with the stated significance of amounts in earlier
prospect least attractive to them.
sections, to indicate that increased significance in amounts
Rankings (30 Four sets of 6 prospects and two sets of 3 prospects were presented. All increases risk aversion, and consequently predictability of
lotteries) sets contained prospects with equal expected values of €1,500, €2,500, preference.
€150, €30,000, €30 and €30,000. The two lottery bundles with the
To compare with responses later on and identify potential
same EV of €30,000 also serve as confirmation on consistency.
preference reversals (Test for preference invariance).
Subjects are offered 6 consecutive pairs of zero-outcome and profit- To approximate the certainty equivalent of each prospect for
outcome prospects and were asked to state the maximum price they each subject.
Willingness to were willing to pay to participate in these prospects. All prospects have
Pay (Zero Loss 6 To identify preference reversals and preference invariance.
the same expected value of €1,500. Probabilities range from 15% up to
Prospects) 90%, with decreasing payouts and increasing probabilities.
Motivation is offered as the highest bidder is awarded the lottery.
161
Appendix B
Questionnaire No of
Description Objective
Section Questions
Based on the subject-specified prices of the above section, prospects are To test if the maximum price initially specified by subjects is
re-introduced in the same sequence and with the same probabilities, indeed the maximum they are willing to pay.
but payouts are now the initial amounts minus the stated prices
To test the existence of framing effects, as prospects are re-
subjects stated they were willing to pay in the previous section. As a
introduced containing the values that the subjects specified.
result, this section contains mixed prospects.
Willingness to To compare potential miscalculations on behalf of the subjects
Subjects state their price to participate in these lotteries, but they can
pay (framing 6 – 24 as risk increases and payouts decrease, and test if their
also choose the option “would not accept this” if the proposed lottery is
options) cumulative willingness to pay diverges more or less as risk
unattractive to them even if offered for free.
increases.
When a subject stated a price of zero or ticked the “would not accept
this” option, the lottery pair was removed from the next spreadsheet.
This section features a maximum total of 4 spreadsheets and a
maximum of 24 lotteries, depending on the non-zero prices given.
Prospects are being offered to subjects and they are asked to state a To confirm the biases mentioned in prior literature according
minimum price at which they are willing to sell their participation. to which the state selling price of subjects is higher than the
These lotteries are spread over three spreadsheets, the first one stated bid price for the same prospect.
featuring the same payout with different probabilities (increasing
Willingness to To confirm that the cumulative willingness to pay price is
18 expected values), the second one featuring the same expected value
Accept acceptable for subjects and that the resulting probability-
across all prospects and which are the same prospects as the ones
payout pairs hold some subjective value to them.
introduced at the first set of the WTP section, and the third set being the
payouts and probability pairs derived using the cumulative sequential
WTP calculations.
162
Appendix B
Presentation of Questionnaire (Print-Screen Version)
Cover Page
Decisions and Preferences among Prospects
Thank you for your participation
Our goal is to determine your preferences among different prospects. There is, obviously, no right and wrong
answer in the attached questionnaire. All that is required is that you state your true preferences in the questions
A couple of things you need to know about this questionnaire:
1. It is important that you complete it all in one go. Please state your name and starting time in the provided boxes below. A relevant
request for your finish time shall be available when you finish.
2. Please follow the correct sequence of questions by clicking the relevant button when provided (in this spreadsheet the "Start"
button and in subsequent spreadsheets the "Next" button), or by choosing the relevant spreadsheet as indicated.
Full Name
Date Time
Day Month Year Hour Minutes
Please state the date and time when you started completing this questionnaire:
Start
163
Appendix B
Background Information
Background information
In this introductory section, we require some personal information about your status quo, your sources of income and your
investment experience. If you are not comfortable answering any of these questions, feel free to leave the answer box blank.
1 What is your age group?
2 Please specify your sex and marital status
3 Dependents
3a. How many children do you have?
3b. Do you financially support your children?
3c. Do you financially support other members of your family?
4 Which member(s) of your family are funding your family expenses or investments?
(please select from the dropdown lists as appropriate)
5 What is your profession?

6 What is your employment level/status?
7 How many years of work experience do you have?
8 Sources of income
8a. Do you have additional sources of income other than income from your profession?
8b. Please specify any additional sources of income
(in the assigned boxes, as appropriate)
8c. Approximately what percentage of your annual income is sourced from

the aforementioned complementary or additional sources?
164
9 Would you characterize yourself as being "well-off"?
10 Are you an active stock market investor?
11 How many years of stock trading experience do you have?
Appendix B
9 Would you characterize yourself as being "well-off"?

10 Are you an active stock market investor?
11 How many years of stock trading experience do you have?
12 How often do you/did you monitor your investment portfolio's performance?
13 Do you/did you invest exclusively in the stock market of your home country?
14 Do you/did you invest in mutual funds?
15 Do you/did you invest in hedge funds?
16 What investment horizon do you/did you usually have in your investments?
17 Do you invest in emerging market stocks or mutual funds?
18 Do you consider yourself to be an experienced investor?
19 Do you consider yourself to be a conservative investor?
20 What is your level of education?
21 Do you/did you invest in derivatives products?
22 Have you ever used derivatives products for hedging purposes?
23 What types of derivatives products have you invested in?
Please proceed to the next page by clicking the "On the Significance of Amounts" tab below
165
Appendix B
Significance of Amounts
Significance of Amounts
Please grade the following amounts by level of significance, assigning numbers from 1 to very insignificant amounts to 5 to the very significant amounts.
An amount that would significantly affect your financial situation, i.e. you would be in long term financial trouble if
[1] Very Significant Amount - Life changing, will have a long term impact on your lifestyle subtracted and significantly better off if added to your current wealth
[2] Significant Amount - Will have a medium term impact on your lifestyle for a while A noteworthy amount, an amount you would not risk losing easily, and which you would be particularly happy to win
An amount that may have some impact on your lifestyle, in the short or medium term, but will not alter your status quo in
[3] Not Very Significant Amount - Will have a temporary impact on your lifestyle a substantial way
[4] Insignificant Amount - Will not have an impact on your lifestyle An amount that would not make a big difference to your daily lifestyle
An amount of no importance to you, for example an amount you could misplace, or would be willing to leave as a tip to
[5] Very insignificant Amount - Goes unnoticed the delivery guy
166
Appendix B
Significance of Positive Amounts
Grade
A. 100.000 euros
B. 3.000 euros
C. 10.000 euros
D. 100 euros
E. 500.000 euros
F. 30.000 euros
G. 2.000.000 euros
H. 70.000 euros
I believe that in order to maintain a comfortable lifestyle, I need this
I.
amount per month:
J. A nice apartment in my desired location would cost me:
The following questions are optional, feel free to leave blank if you are not comfortable disclosing this information:
(Please include family assets if you keep your family finances joint between yourself and your spouse / parents)
K. My net monthly income is: ( net of taxes, prior to making any other payments, purchases, etc )
L. My real estate assets are worth approximately:
The amount I have allocated to investment products
M.
(eg. Stocks, mutual funds):
N. My disposable income per month is approximately:
Next Page
167
Appendix B
Significance of Negative Amounts
Please grade the following amounts by level of significance, assigning numbers from 1 to very significant amounts to 5 to very insignificant amounts.
Very Significant Amount - Life changing, will have a long term An amount that would significantly affect your financial situation, i.e. you would be in long term financial
[1] trouble if subtracted and significantly better off if added to your current wealth
impact on your lifestyle
Significant Amount - Will have a medium term impact on your A noteworthy amount, an amount you would not risk losing easily, and which you would be particularly
[2] happy to win
lifestyle for a while
Not Very Significant Amount - Will have a temporary impact An amount that may have some impact on your lifestyle, in the short or medium term, but will not alter
[3] your status quo in a substantial way
on your lifestyle
[4] Insignificant Amount - Will not have an impact on your lifestyle An amount that would not make a big difference to your daily lifestyle
[5] Very insignificant Amount - Goes unnoticed An amount of no importance to you, for example an amount you could misplace
Grade
A. -100.000 euros
B. -3.000 euros
C. -10.000 euros
D. -100 euros
E. -500.000 euros
F. -30.000 euros
G. -2.000.000 euros
H. -70.000 euros
168
Appendix B
Rankings
Rankings
Suppose you are being offered
[1] First choice, most preferred option
the following set of prospects.
[2] [1] First choice, most preferred option
Please rank these prospects
[3] OR [2]
according to your preferences.
[4] [3] Least preferred option, last choice
Please assign [1] to your
[5]
preferred prospect, [2] to your
[6] Least preferred option, last choice
second choice, and so on.
Question 1 Probability Payout Your Rank

15% 10.000 €
30% 5.000 €
45% 3.350 €
60% 2.500 €
75% 2.000 €
90% 1.650 €

25% 10.000 €
50% 5.000 €
75% 3.350 €
169
Appendix B
15% 1.000 €
30% 500 €
45% 335 €
60% 250 €
75% 200 €
90% 165 €
15% 200.000 €
30% 100.000 €
45% 67.000 €
60% 50.000 €
75% 40.000 €
90% 33.000 €
170
Appendix B

15% 200 €
30% 100 €
45% 67 €
60% 50 €
75% 40 €
90% 33 €
25% 120.000 €
50% 60.000 €
75% 40.200 €
Next Page
171
Appendix B
Willingness to Pay (WTP)
Note: For this section of the questionnaire, I present the completed questionnaire section by one of the subjects, in order to show what
the setup of the questions is. The questionnaire is computer based and automatically updates the prices on the WTP2 – WTP5 question
sheets, according to the WTP1 entries of the respondents.
Pay-for-Ticket
This is a collection of prospects which you will be asked to pay to participate in.
Please state the MAXIMUM amount you will be willing to pay to take a chance at the assigned
lotteries.
In order to help you focus and make your effort worthwhile, we will offer each of the following
options to the higher bidder of each prospect upon completion of the questionnaire.
172
Appendix B
WTP1
Pay for Ticket
Please provide a Euro amount that is the maximum amount of money you would spend to purchase
your participation in the prospect. If you would pay a maximum of zero euros, please enter the zero (0).
We would like to remind you that we are asking you to state the absolute maximum amount you would be
willing to pay to participate in the following prospects. In other words we are looking for the amount above
which you would not participate in the prospect.
Probability Payout Your Price Next Hide All Next Page

15% 10.000 €
50 €
85% 0€
30% 5.000 € WTP1
50 €
70% 0€
45% 3.350 €
150 €
55% 0€
60% 2.500 €
150 €
40% 0€
75% 2.000 €
250 €
25% 0€
90% 1.650 €
250 €
10% 0€
173
Appendix B
WTP2
Would not Unhide Next Hide All Next Page

Probability Payout Your Price accept this
15% 9.950 €
0€
85% -50 €
30% 4.950 €
0€
70% -50 €
45% 3.200 €
50 €
55% -150 €
60% 2.350 €
50 €
40% -150 €
75% 1.750 €
150 €
25% -250 €
90% 1.400 €
250 €
10% -250 €
174
Appendix B
WTP3
Would not accept

Probability Payout Your Price this prospect
Unhide Next Hide All Next Page
45% 3.150 €
150 €
55% -200 €
60% 2.300 €
150 €
40% -200 €
75% 1.600 €
150 €
25% -400 €
90% 1.150 €
150 €
10% -500 €
175
Appendix B
WTP4
Would not accept

45% 3.000 €
250 €
55% -350 €
60% 2.150 €
250 €
40% -350 €
75% 1.450 €
0€
25% -550 €
90% 1.000 €
0€
10% -650 €
176
Appendix B
WTP5
Would not accept

45% 2.750 €
0€
55% -600 €
60% 1.900 €
0€
40% -600 €
177
Appendix B
Willingness to Accept (WTA)
Sell Your Ticket

Assume that the prospects that follow are available to you for free.
Please state the MINIMUM amount of money you would require in order to forego the
prospects.
Please click the WTA1 tab below to proceed
178
Appendix B
WTA1
Sell Your Ticket

This section contains a series of prospects offered to you for free. You are required to specify the payment you would like to receive in cash (with 100%
probability) in order to forego the opportunity to take the prospect.
For example, suppose you already had secured the prospect "Win $2,500 with 90% probability", and you are now asked to state an amount that you would require to be given as a "profit"
in order to not participate in this prospect. If your answer is $200, this means that you will be paid $200 and lose your right to participate in the prospect of winning $25 with a 90%
probability and $0 with 10% probability. It also means that $200 is the minimum amount you would accept to bypass this opportunity, i.e. if we offered you $190 to forego the prospect,
you would refuse and prefer the 90%/10% prospect.
We would like to remind you that we are asking you to state the minimum amount you would accept to not participate in the following prospects. In other
words we are looking for the amount you would require as payment below which you would rather take the prospect.
Probability Payout Your Compensation Requirement Next Page

15% 25.000 €
85% 0€
Probability Payout Your Compensation Requirement
30% 25.000 €
70% 0€
45% 25.000 €
55% 0€
60% 25.000 €
40% 0€
75% 25.000 €
25% 0€
90% 25.000 €
10% 0€
179
Appendix B
WTA2

15% 10.000 € Next Page
85% 0€
30% 5.000 €
70% 0€
45% 3.350 €
55% 0€
60% 2.500 €
40% 0€
75% 2.000 €
25% 0€
90% 1.650 €
10% 0€
180
Appendix B
WTA3
Note: This section draws values from the WTP section of the questionnaire. I present here the values with the entries of the random
respondent drawn from the sample, for illustration purposes.

15% 9.950 €
85% -50 €
30% 4.950 €
70% -50 €
45% 3.000 €
55% -600 €
60% 2.150 €
40% -600 €
75% 1.450 €
25% -550 €
90% 1.000 €
10% -650 €
181
Appendix B
Final Page
Decisions and Preferences among Prospects
Thank you for your contribution

Date Time
Please state the date and time when you finished completing this questionnaire:
182
Appendix C – Statistical Analysis
C.1 The Significance of Amounts
Table C-1: Subjective Significance of Gains and Losses 54

A/A € -€ € -€ € -€ € -€ € -€ € -€ € -€ € -€
100 100 3k 3k 10k 10k 30k 30k 70k 70k 100k 100k .5m .5m 2m 2m
1 4 4 4 3 4 2 3 2 3 1 2 1 1 1 1 1
2 3 3 2 2 2 1 1 1 1 1 1 1 1 1 1 1
3 5 4 4 2 3 1 3 1 1 1 2 1 1 1 1 1
4 4 4 3 3 2 2 2 2 1 1 2 1 1 1 1 1
5 5 4 4 3 3 2 2 2 2 1 2 1 1 1 1 1
6 5 4 4 3 4 2 3 2 2 1 2 1 1 1 1 1
7 5 4 5 3 4 3 4 1 2 1 2 1 1 1 1 1
8 5 4 4 3 3 2 3 3 2 1 2 1 2 1 1 1
9 5 4 4 3 3 3 3 3 2 1 2 1 1 1 1 1
10 4 4 3 2 3 2 3 2 2 1 2 1 1 1 1 1
11 4 4 3 3 3 2 2 2 2 1 2 1 2 1 1 1
12 5 4 4 2 3 2 2 2 2 1 2 1 1 1 1 1
13 4 4 4 2 4 2 2 2 1 1 1 1 1 1 1 1
14 4 4 4 3 3 2 2 2 1 1 1 1 1 1 1 1
15 4 4 3 3 3 2 3 2 2 1 1 1 1 1 1 1
16 4 4 3 2 3 2 3 2 3 1 2 1 2 1 1 1
17 4 4 3 3 3 2 3 2 2 1 2 1 1 1 1 1
18 5 5 4 2 3 2 3 2 2 1 2 1 1 1 1 1
19 4 4 3 3 3 3 3 2 2 1 2 1 1 1 1 1
20 4 4 3 2 3 2 3 2 2 1 2 1 1 1 1 1
21 5 4 4 2 4 2 3 2 2 1 2 1 1 1 1 1
22 4 4 4 2 3 2 3 2 3 1 2 1 2 1 1 1
23 5 5 4 3 4 2 3 2 2 1 2 1 1 1 1 1
24 4 4 3 2 3 2 3 1 2 1 1 1 1 1 1 1
25 5 5 4 2 4 2 4 3 3 1 2 1 1 1 1 1
26 4 4 4 2 4 2 4 2 3 1 2 1 2 1 1 1
27 5 4 3 2 2 2 2 1 2 1 2 1 1 1 1 1
28 5 4 4 2 3 2 2 1 1 1 2 1 1 1 1 1
29 5 4 3 2 3 2 2 2 2 1 2 1 1 1 1 1
30 5 5 4 2 3 2 3 2 3 1 2 1 2 1 1 1
31 5 5 5 3 4 2 2 2 1 1 1 1 1 1 1 1
32 5 5 4 2 3 2 3 2 2 1 2 1 1 1 1 1
33 5 5 4 2 3 2 3 2 2 1 2 1 1 1 1 1
34 4 4 3 2 2 2 1 1 1 1 1 1 1 1 1 1
35 5 4 4 3 3 2 3 2 2 1 2 1 2 1 1 1
36 5 4 3 2 2 2 1 1 1 1 1 1 1 1 1 1
37 5 5 3 2 2 2 2 1 2 1 1 1 1 1 1 1
38 5 5 3 2 3 2 2 2 2 1 2 1 1 1 1 1
39 5 4 3 2 3 2 2 2 2 1 1 1 1 1 1 1
40 5 4 2 2 2 2 2 1 2 1 1 1 1 1 1 1
41 5 5 4 4 3 3 2 2 2 1 2 1 1 1 1 1
42 4 4 3 3 3 3 2 1 2 1 2 1 1 1 1 1
43 5 4 5 3 4 2 3 2 2 1 2 1 1 1 1 1
44 5 4 3 2 3 2 2 1 2 1 1 1 1 1 1 1
45 4 4 3 2 2 2 2 1 1 1 1 1 1 1 1 1
46 5 4 4 3 3 2 3 1 2 1 2 1 1 1 1 1
47 4 4 2 2 2 2 1 1 1 1 1 1 1 1 1 1
54 The amount categorization is the following: 1=Very Significant, 2=Significant, 3=Not Very
Significant, 4=Insignificant, 5=Very Insignificant.
183
Appendix C
48 5 4 4 3 4 2 2 1 2 1 2 1 1 1 1 1
49 5 5 5 4 3 2 3 1 3 1 2 1 1 1 1 1
50 5 5 4 4 4 2 3 2 3 2 3 1 3 1 2 1
51 5 4 3 3 3 2 3 2 2 1 2 1 1 1 1 1
52 3 3 2 2 2 2 4 2 1 1 1 1 1 1 1 1
C.2 Rankings
Table C- 2: Rankings of LBs
Ranking with with with with

EV=€30 EV=€150 EV=€1,500 EV=€30,000
123456 38 (73.08%) 26 (50%) 4 (7.69%) 2 (3.85%)
132456 1 (1.92%) 0 0 0
136542 0 0 0 1 (1.92%)
214563 0 1 (1.92%) 0 0
234561 0 0 1 (1.92%) 0
243561 0 0 1 (1.92%) 0
265431 0 0 1 (1.92%) 0
312456 0 3 (5.77%) 0 0
321456 1 (1.92%) 0 1 (1.92%) 0
326145 0 0 1 (1.92%) 0
342165 0 0 0 1 (1.92%)
346512 0 0 1 (1.92%) 0
365412 0 0 1 (1.92%) 0
365421 0 0 1 (1.92%) 0
412536 0 0 0 1 (1.92%)
421356 0 1 (1.92%) 0 0
431256 0 0 1 (1.92%) 0
452136 0 0 0 1 (1.92%)
456213 0 0 1 (1.92%) 0
465123 0 0 2 (3.85%) 0
521346 1 (1.92%) 1 (1.92%) 0 0
531246 0 1 (1.92%) 0 0
532146 0 0 1 (1.92%) 0
541236 0 2 (3.85%) 0 0
541326 0 0 0 1 (1.92%)
542136 1 (1.92%) 0 2 (3.85%) 0
543126 1 (1.92%) 0 0 0
563412 0 1 (1.92%) 0 0
564231 0 0 1 (1.92%) 0
612345 0 0 1 (1.92%) 0
621345 1 (1.92%) 2 (3.85%) 0 0
621354 0 0 1 (1.92%) 0
621435 0 0 0 1 (1.92%)
631245 0 1 (1.92%) 0 0
632145 1 (1.92%) 0 0 0
641235 1 (1.92%) 0 0 0
642351 0 0 1 (1.92%) 0
645231 0 0 0 1 (1.92%)
651234 0 0 1 (1.92%) 2
652134 0 0 1 (1.92%) 0
653124 0 0 1 (1.92%) 1 (1.92%)
184
Appendix C
Ranking with with with with

EV=€30 EV=€150 EV=€1,500 EV=€30,000
653214 0 1 (1.92%) 0 0
653412 0 0 1 (1.92%) 0
654123 0 2 (3.85%) 3 (5.77%) 0
654132 0 0 1 (1.92%) 2 (3.85%)
654213 2 (3.85%) 0 1 (1.92%) 2 (3.85%)
654312 1 (1.92%) 1 (1.92%) 1 (1.92%) 0
654321 3 (5.77%) 9 (17.31%) 19 (36.54%) 36 (69.23%)
Recoding Validity Test
Table C- 3: Fisher’s Exact Tests for Recoded Rank Orderings
a. Compatibility of Frequencies in Lottery Bundle 1 (EV=€30)

Frequency 123 213 312 321 Total P-VALUE
123456 38 0 0 0 38
132456 1 0 0 0 1
321456 0 1 0 0 1
521346 0 1 0 0 1
542136 0 0 1 0 1
543126 0 0 1 0 1
621345 0 1 0 0 1 <0.00001
632145 0 1 0 0 1
641235 0 0 1 0 1
654213 0 0 0 2 2
654312 0 0 0 1 1
654321 0 0 0 3 3
Total 39 4 3 6 52
b. Compatibility of Frequencies in Lottery Bundle 2 (EV=€150)
Frequency 123 132 213 312 321 Total P-VALUE
123456 26 0 0 0 0 26
214563 0 1 0 0 0 1
312456 3 0 0 0 0 3
421356 0 0 1 0 0 1
521346 0 0 1 0 0 1
531246 0 0 1 0 0 1
541236 0 0 0 2 0 2
563412 0 0 0 0 1 1 <0.00001
621345 0 0 2 0 0 2
631245 0 0 1 0 0 1
653214 0 0 0 0 1 1
654123 0 0 0 2 0 2
654312 0 0 0 0 1 1
654321 0 0 0 0 9 9
Total 29 1 6 4 12 52
185
Appendix C
c. Compatibility of Frequencies in Lottery Bundle 3 (EV=€1,500)

Frequency 123 213 231 312 321 Total p-Value
123456 4 0 0 0 0 4
234561 0 0 1 0 0 1
243561 0 0 1 0 0 1
265431 0 0 1 0 0 1
321456 0 1 0 0 0 1
326145 0 1 0 0 0 1
346512 0 0 1 0 0 1
365412 0 0 1 0 0 1
365421 0 0 1 0 0 1
431256 0 1 0 0 0 1
456213 0 0 0 0 1 1
465123 0 0 0 2 0 2
532146 0 1 0 0 0 1
542136 0 0 0 2 0 2
<0.00001
564231 0 0 0 0 1 1
612345 1 0 0 0 0 1
621354 0 1 0 0 0 1
642351 0 0 0 0 1 1
651234 0 0 0 1 0 1
652134 0 0 0 1 0 1
653124 0 0 0 1 0 1
653412 0 0 0 0 1 1
654123 0 0 0 3 0 3
654132 0 0 0 1 0 1
654213 0 0 0 0 1 1
654312 0 0 0 0 1 1
654321 0 0 0 0 19 19
Total 5 5 6 11 25 52
d. Compatibility of Frequencies in Lottery Bundle 4 (EV=€30,000)
Frequency 123 132 213 312 321 Total p-Value
123456 2 0 0 0 0 2
136542 0 1 0 0 0 1
342165 0 0 1 0 0 1
412536 1 0 0 0 0 1
452136 0 0 0 1 0 1
541326 0 0 0 1 0 1 <0.00001
621435 0 0 1 0 0 1
645231 0 0 0 0 1 1
651234 0 0 0 2 0 2
653124 0 0 0 1 0 1
654132 0 0 0 2 0 2
186
Appendix C
654213 0 0 0 0 2 2
654321 0 0 0 0 36 36
Total 3 1 2 7 39 52
Significance Test for Impact of Expected Value on Risk Appetite
Table C- 4: Wilcoxon’s Test Results for Impact of EV on Risk Appetite
Wilcoxon Scores (Rank Sums) for Rankings classified by Bundle

Bundle N Sum of Expected Std Dev Mean Score
Scores Under Under
52 3882.00 8138.0 552.91 74.65
52 5311.00 8138.0 552.91 102.13
52 8886.50 8138.0 552.91 170.89
52 9068.50 8138.0 552.91 174.39
52 10658.50 8138.0 552.91 204.97
52 11021.50 8138.0 552.91 211.95
Average scores were used for ties
Kruskal – Wallis Test
Chi-Square 115.0293
DF 5
Pr > Chi-Square <.0001
C.3 Contingent Valuation
Table C- 5: Willingness to Pay Amounts: Win-Only Section

Amount
Range N % N % N % N % N % N %
€0-€50 29 55.8% 28 53.8% 17 32.7% 15 29% 11 21.2% 6 11.5%
€51-€100 15 28.8% 9 17.3% 15 28.8% 9 17% 7 13.5% 8 15.4%
€101-€150 2 3.8% 7 13.5% 6 11.5% 8 15.4% 6 11.5% 2 3.8%
€151-€200 2 3.8% 3 5.8% 5 9.6% 10 19.2% 11 21.2% 8 15.4%
€201-€250 - 0% 1 1.9% 1 1.9% 2 3.8% 3 5.8% 4 7.7%
€251-€300 2 3.8% 2 3.8% 2 3.8% 1 1.9% 5 10% 6 11.5%
€301-€350 - 0% - 0% 2 3.8% 1 1.9% - 0% 1 1.9%
€351-€400 1 1.9% - 0% 1 1.9% 2 3.8% 2 3.8% 1 1.9%
€401-€450 - 0% - 0% - 0% - 0% - 0% 1 1.9%
€451-€500 1 1.9% 1 1.9% 1 1.9% 1 1.9% 2 3.8% 8 15.4%
€501-€550 - 0% - 0% - 0% - 0% - 0% - 0%
€551-€600 - 0% - 0% - 0% - 0% 1 1.9% - 0%
€601-€650 - 0% - 0% - 0% 1 1.9% - 0% - 0%
€651-€700 - 0% 1 1.9% 1 1.9% - 0% - 0% 1 1.9%
€701-€750 - 0% - 0% - 0% - 0% 1 1.9% 1 1.9%
€751-€800 - 0% - 0% - 0% 1 1.9% 1 1.9% 1 1.9%
€801-€850 - 0% - 0% - 0% - 0% - 0% - 0%
€851-€900 - 0% - 0% - 0% - 0% - 0% 1 1.9%
€901-€950 - 0% - 0% - 0% - 0% 1 1.9% - 0%
€951-€1000 - 0% - 0% - 0% 1 1.9% 1 1.9% 1 1.9%
187
Appendix C
Amount
Range
€1000+ - 0% - 0% 1 1.9% - 0% - 0% 1 1.9%
Significance Tests for Section Values
Table C- 6: Wilcoxon’s Test Results Results for WTP Value Changes
Lottery Significance p-value

vs No <0.0005
vs No <0.0005
vs No <0.0005
vs No <0.0005
vs No <0.0005
vs Yes 0.0099
vs Yes 0.0027
vs Yes 0.0053
vs Yes 0.0007
Sequential Equivalence WTP Values (SWTP)
Table C- 7: Sequential WTP (SWTP)
Amount
€10,000; €5,000; €3,350; €2,500; €2,000; €1,650;
Range 15% 30% 45% 60% 75% 90%
N % N % N % N % N % N %
€0-€50 24 46.2% 14 26.9% 5 9.6% 5 9.6% 2 4% 1 1.9%
€51-€100 10 19.2% 11 21.2% 8 15.4% 4 7.7% 4 7.7% 3 5.8%
€101-€150 2 3.8% 10 19.2% 12 23.1% 7 13.5% 6 11.5% 1 1.9%
€151-€200 4 7.7% 3 5.8% 8 15.4% 9 17.3% 4 7.7% 3 5.8%
€201-€250 1 1.9% 2 3.8% 2 3.8% 8 15.4% 5 10% 1 1.9%
€251-€300 3 5.8% 1 1.9% 2 3.8% 1 1.9% 5 10% 3 5.8%
€301-€350 0 0% 2 3.8% 0 0% 3 5.8% 2 4% 1 1.9%
€351-€400 1 1.9% 1 1.9% 3 5.8% 3 5.8% 6 11.5% 10 19.2%
€401-€450 2 3.8% 1 1.9% 1 1.9% 1 1.9% 1 1.9% 2 3.8%
€451-€500 3 5.8% 1 1.9% 2 3.8% 2 3.8% 1 1.9% 2 3.8%
€501-€550 0 0% 1 1.9% 0 0% 0 0% 3 5.8% 2 3.8%
€551-€600 1 1.9% 0 0% 1 1.9% 1 1.9% 3 5.8% 2 3.8%
€601-€650 0 0% 1 1.9% 1 1.9% 0 0% 0 0% 2 3.8%
€651-€700 0 0% 2 4% 0 0% 0 0% 0 0% 2 3.8%
€701-€750 0 0% 0 0% 1 1.9% 1 1.9% 0 0% 2 3.8%
€751-€800 0 0% 0 0% 1 1.9% 0 0% 1 1.9% 3 5.8%
€801-€850 1 1.9% 1 1.9% 1 1.9% 0 0% 1 1.9% 1 1.9%
€851-€900 0 0% 0 0% 0 0% 0 0% 0 0% 3 5.8%
€901-€950 0 0% 1 1.9% 0 0% 1 1.9% 1 1.9% 0 0%
€951-€1k 0 0% 0 0% 1 1.9% 1 1.9% 0 0% 0 0%
€1,001-€1.1k 0 0% 0 0% 2 3.8% 3 5.8% 2 3.8% 1 1.9%
€1,101-€1.2k 0 0% 0 0% 0 0% 1 1.9% 3 5.8% 2 3.8%
188
Appendix C
Amount
€10,000; €5,000; €3,350; €2,500; €2,000; €1,650;
Range 15% 30% 45% 60% 75% 90%
N % N % N % N % N % N %
€1,201-€1.3k 0 0% 0 0% 0 0% 0 0% 0 0% 0 0%
€1,301-€1.4k 0 0% 0 0% 1 1.9% 0 0% 0 0% 2 3.8%
€1,401-€1.5k 0 0% 0 0% 0 0% 0 0% 0 0% 2 3.8%
€1,501+ 0 0% 0 0% 0 0% 1 1.9% 2 3.8% 1 1.9%
Significance of Differences in SWTP Values
Table C- 8: Wilcoxon’s Test Results for SWTP Value Changes

vs Not Significant 0.1458
vs Significant 0.0175
vs Significant <0.0001
Willingness to Accept Values
Table C- 9: Willingness to Accept Prices
Amount Range
N % N % N % N % N % N %
€0-€50 4 7.7% 3 5.8% 2 3.8% 0 0% 0 0% 0 0%
€51-€100 7 13.5% 2 3.8% 1 1.9% 2 3.8% 0 0% 0 0%
€101-€150 2 3.8% 1 1.9% 1 1.9% 1 1.9% 1 1.9% 0 0%
€151-€200 6 11.5% 6 11.5% 4 7.7% 3 5.8% 2 3.8% 1 1.9%
€201-€250 2 3.8% 4 7.7% 2 3.8% 1 1.9% 1 1.9% 1 1.9%
€251-€300 3 5.8% 3 5.8% 3 5.8% 3 5.8% 1 1.9% 0 0%
€301-€350 0 0% 1 1.9% 1 1.9% 0 0% 1 1.9% 1 1.9%
€351-€400 1 1.9% 2 3.8% 4 7.7% 3 5.8% 2 3.8% 0 0%
€401-€450 0 0% 0 0% 1 1.9% 0 0% 0 0% 0 0%
€451-€500 9 17.3% 11 21.2% 7 13.5% 8 15.4% 8 15.4% 6 11.5%
€501-€550 0 0% 0 0% 0 0% 1 1.9% 0 0% 0 0%
€551-€600 0 0% 0 0% 1 1.9% 3 5.8% 2 3.8% 0 0%
€601-€650 0 0% 0 0% 0 0% 0 0% 0 0% 1 1.9%
€651-€700 3 5.8% 3 5.8% 1 1.9% 2 3.8% 2 3.8% 1 1.9%
€701-€750 0 0% 1 1.9% 1 1.9% 0 0% 0 0% 0 0%
€751-€800 1 1.9% 0 0% 2 3.8% 1 1.9% 3 5.8% 2 3.8%
€801-€850 0 0% 0 0% 0 0% 0 0% 0 0% 1 1.9%
€851-€900 0 0% 0 0% 1 1.9% 1 1.9% 0 0% 1 1.9%
€901-€950 0 0% 0 0% 0 0% 0 0% 0 0% 0 0%
189
Appendix C
€951-€1,000 6 11.5% 4 7.7% 9 17.3% 8 15.4% 13 25% 13 25.0%

€1.0k-€1.1k 0 0% 0 0% 0 0% 1 1.9% 1 1.9% 0 0%
€1,101-€1,2k 1 1.9% 0 0% 0 0% 1 1.9% 3 5.8% 2 3.8%
€1,201-€1,3k 0 0% 1 1.9% 2 3.8% 1 1.9% 2 3.8% 4 7.7%
€1,301-€1,4k 0 0% 0 0% 0 0% 2 3.8% 3 5.8% 3 5.8%
€1,401-€1,5k 0 0% 5 9.6% 5 9.6% 6 11.5% 4 7.7% 14 26.9%
€1,501+ 7 13.5% 5 9.6% 4 7.7% 4 7.7% 3 5.8% 1 1.9%
Significance of Differences in WTA Values
Table C- 10: Wilcoxon’s Test Results for WTA Value Changes

vs Significant 00412
Significance Tests for Cross-Sectional Data
Table C- 11: Wilcoxon’s Test Results for SWTP-WTP
Lottery Mean Median Statistic p-value

68.115 2 175.5
97.558 20 280.5
148.865 50 370.5
<0.0001
168.904 81.5 370.5
213.154 120 410
248.808 205 495
Table C- 12: Wilcoxon’s Test Results for WTA-WTP

688.442 299 584
626.077 363.5 612.5
<0.0001
624.615 400 638
662.596 450 637.5
190
Appendix C
672.404 675 634.5

751.731 800 661
Table C- 13: Wilcoxon’s Test Results for WTA-SWTP

620.327 250 520.5
528.519 325 579.5
475.750 300 539.5
<0.0001
493.692 350 552
459.250 400 573
466.923 525 554
Table C- 14: Wilcoxon’s Test Results for SWTP/WTP

2.16211 1.200 175.5
2.55315 1.550 280.5
3.71975 2.000 370.5
<0.0001
2.87461 1.775 370.5
2.42665 2.000 410.0
2.63809 2.000 495.0
Table C- 15: Wilcoxon’s Test Results for WTA/WTP

26.5127 7.33333 509.5
17.8886 7.08333 564.0
17.3800 5.00000 634.5
<0.0001
12.8776 5.00000 637.5
8.0429 5.00000 634.5
7.3571 4.75000 659.5
Table C- 16: Wilcoxon’s Test Results for WTA/SWTP

16.0525 4.08333 463.0
11.8313 3.16667 557.0
5.2273 2.50000 603.5
<0.0001
4.4315 2.7389 617.5
3.5316 2.50000 635.0
3.2653 1.93750 590.0
191
Appendix C
Significance Tests for WTA and SWTA Data
Table C- 17: Wilcoxon’s Test Results for WTA vs C+|Max Loss|
Lottery Significant p-value

Disparity
No 0.1357
No 0.0887
No 0.1115
No 0.2524
No 0.3303
No 0.6141
192
Abbreviations
ARA Absolute Risk Aversion

BDM Becker, DeGroot and Marschak
CARA Constant Absolute Risk Aversion
CE Certainty Equivalent
CEF Certainty Equivalent Factor
CPT Cumulative Prospect Theory
CV Contingent Valuation
EU / EUH / EUT Expected Utility / Theory / Hypothesis
EV Expected Value
HARA Hyperbolic Absolute Risk Aversion
L Lottery
LARA Loss Adjusted Risk Aversion
LB Lottery Bundle
PT Prospect Theory
RRA Relative Risk Aversion
SE Sequential Equivalence
SWTA Sequential Willingness to Accept
SWTP Sequential Willingness to Pay
vNM Von Neumann and Morgenstern
WTA Willingness to Accept
WTP Willingness to Pay
193
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Financial Decisions Under Risk: A Study of Revealed Preferences

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University of Athens

Doctoral Program in Economics

“Financial Decisions Facing Risk”

Professor Panagiotis Alexakis

Athens, June 2013

The theoretical foundations of economic theory on financial decisions facing risk

Table 1.1: Risk Appetite According to Prospect Theory ................................................. 5

Figure 1.1: The Assessment of Risky Prospects ................................................................... 3

Working on this Ph.D. has been an overwhelming, humbling and challenging

Katerina Moulin – Mita

Human behaviour is a fascinating field of study for a wide variety of sciences

All decisions share a common characteristic: they materialize in the future, as

The interdisciplinary nature of financial decision making facing risk borders

Building on the existing literature, it is evident that choice and revealed

independently become the subject of prolific analysis and insightful research,

Figure 1.1: The Assessment of Risky Prospects

Objective Perspective Compared to each

Compared to reference point

High Probability Low Probability

The assessment of prospective payouts is assumed to be a function of final

of payouts in terms of their subjective significance is introduced. Moreover, the

A common illustration that simplifies the analysis of a risky financial prospect is

Indeed in financial decision making the impact of subjectivity is fundamental.

that a non-parametric analysis of the components of financial decisions is

The impact of the subjective significance of payouts on decisions under risk

Table 1.1: Risk Appetite According to Prospect Theory

Outcome Probability Risk Seeking Risk Averse

Table 1.2: Drivers of Choice According to Risk Profile

Risk Appetite Gain Problems Loss Problems

As implied by behavioural finance theorists, there is an interaction of payouts

Figure 1.2: Contribution of Payouts and Probabilities to Binary Lottery Risk

Positive Mixed Negative

Risky Less Risk Moderate Risk High Risk

High for Desirable Low for Desirable

Given the importance of the accurate extraction of certainty equivalents, it is

methodology essentially traces framing effects and reverses their impact to

Subjects are professional or skilled individual investors, with investment

A final consideration is the theoretical framework within which risky

The subjective assessment of risky prospects, on which the construction of

In response to the above theoretical arguments widely available in prior

In fact, it is precisely the descriptive failure of normative theory that points to

The methodological shortcomings, including those related to experimental

Secondly, acknowledging the asymmetric assessment of gains and losses (“loss

confirmed but a critical underestimation of the amount decision makers are

2.1 Some Definitions

2.1.1 Financial Decisions

With investment products, two assumptions are traditionally made: a) Investors

It is common for researchers to reduce risky choice to choice among lotteries or

risk is defined in section 2.4 later on.

This risky prospect is essentially equivalent to a synthetic option investment to

This risky prospect is essentially equivalent to an exit strategy of an investor

Preference ordering can be measured on ordinal and cardinal scales. Ordinal

A strong or weak preference relation ( respectively) reveals the ranking

Ranking refers to the method of ordering alternative goods and/or services, or

Utility is the satisfaction derived from the consumption of a good or service.

personal preferences inherent to each individual. In practical terms utility8 is the

A very particular utility pertains to a commodity that, in theory, people

a. Concavity – Diminishing marginal utility is derived from positive monetary

Criticism on the use of utility as a way to rank, compare or understand

2.2.4 Risk versus Uncertainty

8 Often referred to as “total utility”, for example in consumption economics

“The sense in which I am using the term is that in which the

Abiding by the distinction between known and unknown probabilities and