Topics

• Expected Utility Theory

Lecture 3: Prospect Theory, • Violations of EUT
• Prospect Theory
Framing, and Mental Accounting • Framing
• Mental Accounting
• Application of Prospect Theory, Framing, and Mental
Accounting: Equity Premium Puzzle

Master of Arts program Nattawut Jenwittayaroje, Ph.D, CFA

in Applied Finance NIDA Business School

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Expected Utility Theory

Utility
The key features are as follows:
• The value is measured by “utility.”
• Utility depends on the state of wealth.
• A rational individual’s utility function is assumed to be a positive
function of wealth.
• The expected utility of a prospect is probability-weighted utility
(i.e., the sum of the products of utilities times their probabilities).
• The weight put on any outcome probability is simply equal to its
probability. x-y x x+y Wealth

• A rational, risk-averse individual’s utility function is assumed to be

a concave function of wealth.

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 Allais Paradox
• The Allais paradox is a choice problem designed by
Maurice Allais to show an inconsistency of actual observed
choices with the predictions of expected utility theory.
Allais question 1:
Which do you prefer?
A. a 100% chance of getting $1,000,000,
or
A* a gamble where the outcomes are as follows:
» a 1% chance of getting nothing
» a 89% chance of getting $1,000,000
» a 10% chance of getting $5,000,000.
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Allais Paradox (con’t)
• From Question 1:
U(1,000,000) > 0.89U(1,000,000) + .10U(5,000,000)
• Rearranging we get:
0.11U(1,000,000) > 0.10U(5,000,000)
• From Question 2:
0.10U(5,000,000) > 0.11U(1,000,000)
Such choices are clearly contradictory!!
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Allais Paradox (con’t)
Allais question 2:
Which do you prefer?
B. a gamble where the outcomes are as follows:
» a 89% chance of getting nothing
» A 11% chance of getting $1,000,000
or
B* a gamble where the outcomes are as follows:
» a 90% chance of getting nothing
» a 10% chance of getting $5,000,000.
Reconsidering Allais Paradox
Modified Question 1:
Which do you prefer?
A. a gamble where the outcomes are as follows:
» a 89% chance of getting $1,000,000
» a 11% chance of getting $1,000,000,
or
A* a gamble where the outcomes are as follows:
» a 89% chance of getting $1,000,000
» a 1% chance of getting nothing
» a 10% chance of getting $5,000,000.
Reconsidering Allais Paradox (con’t) Reconsidering Allais Paradox (con’t)
Modified question 2:
• Notice that after removing commonalities, now the
Which do you prefer?
choices between prospect A and A* or B and B* are
exactly the same!
B. a gamble where the outcomes are as follows:
» a 89% chance of getting nothing
» A 11% chance of getting $1,000,000 • Thus people should choose (A and B) or (A* and B*).
or
B* a gamble where the outcomes are as follows: • Without such aids, many people do not seem to
» a 89% chance of getting nothing understand the structure of the decision and choose
» a 1% chance of getting nothing A and B*.
» a 10% chance of getting $5,000,000.

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Problems with expected utility theory Problems with expected utility theory
• A number of violations of expected utility have been discovered.

• Expected utility theory assumes that people should have consistent • A number of violations of expected utility have been
choices, regardless of presentation (i.e., frame). discovered.
• Alternative theories have been developed which
• A decision frame is defined to be a decision-maker’s view of the
seek to account for these violations.
problem and possible outcomes.
• A frame is affected by the presentation mode and the • Best-known is prospect theory of Daniel Kahneman
individual’s perception of the question, and personal and Amos Tversky.
characteristics.
• People have different perspectives and come up with different
decisions depending on how a problem is framed.
• Sometimes frames are opaque, and thus trickier to see through.
• For this reason, a change in frame can lead to a change in
decision, as in Allais questions. 11 12
 Prospect theory Risk aversion vs. risk seeking
• Prospect theory was developed by Kahneman and • Prospect pair 1 -- choose between:
Tversky base on observing actual behavior. • A: (.5, 6,000, 0.5, 0)
• B: (3,000)
• Experimental evidence says that people often behave
• In other words, the choice is between a sure gain of $3,000
contrary to expected utility theory. and a 50% chance to gain 6,000.
• Expected utility theory is normative.
• Prospect pair 2 – choose between:
– What people should do • C: (.5, -6,000, 0.5, 0)
• While prospect theory is positive. • D: (-3,000)
• In other words, the choice is between a sure loss of $3,000
– What people actually do and a 50% chance to lose 6,000.
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Key Aspect 1 Reference Point

• For Prospect pair 1, 84% of the respondents chose B, If you are richer by $5,000 and you have to choose
consistent with risk aversion. between
• For Prospect pair 2, 84% of the respondents chose C, A) a 50% chance to win $6,000 and a 50% chance to win
consistent with risk seeking. nothing
• Expected Utility theory cannot incorporate changes in risk B) receive $3,000.
attitude like this.
If you are richer by $11,000 and you have to choose
• People sometimes exhibit risk aversion and sometimes exhibit between
risk seeking, depending on the nature of the prospect. C) a 50% chance to lose $6,000 and a 50% chance to lose
nothing
D) lose $3,000

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 Key Aspect 2 Loss aversion
• Notice that the two decisions are effectively the same.
• Prospect pair 3 -- choose between:
• But 72% chose B) and 64% chose C)
• A: no prospect
• The problem shows that risk attitude is not the same across
gains and losses. • B: (0.5, $100, -$100)
• seem gains or losses is what people care about, rather than the
level of wealth. • A is the status quo. Most choose A.
• People evaluate an outcome based on the gain or loss from a
reference point (usually taken to be current wealth or status quo).
• Losses loom larger than gains. In other words, the loss of
• Expected Utility theory  people value outcomes based on the $100 is more painful than a gain of $100 is pleasurable.
final wealth position, regardless of the person’s initial wealth.
• Peoples’ valuations of prospects depend on gains and losses
• This is called loss aversion.
relative to a reference point. This reference point is usually the
status quo.
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Key Aspect 3 Development of prospect theory

• Prospect pair 4 -- choose between: • These and other results led to prospect theory as an
• A: no prospect alternative to expected utility theory.
• B: (0.5, $X, -$25) • Key precepts:
• Value function in prospect theory replaces the utility
 What value of X would make you indifferent between A function in expected utility theory.
and B? • Value is in terms of gains or losses, relative to a
reference point (usually the status quo).
 The average person requires a gain of $61 to be • Risk aversion (i.e., concave) in positive domain
indifferent between accepting or rejecting the gamble. • Risk seeking (i.e., convex) in negative domain
• Loss aversion  people dislike losses, so the value
• People are averse to losses because losses loom larger function is steeper for losses than for gains.
than gains.
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 (Utility) Value Expected Utility (EU) vs Prospect Theory
• Barberis and Thaler (2003) 
$100 “Should financial economists be interested in… alternatives to
expected utility? It may be that EU theory is a good approximation to
how people evaluate a risky gamble like the stock market, even if it
does not explain attitudes to the kinds of gambles studied in
Losses($) $100 Gains ($) experimental settings.”
• However, they go on to say:
“On the other hand, the difficulty the EU approach has encountered in
trying to explain basic facts about the stock market suggests that it
may be worth taking a closer look at the experimental evidence.
Indeed, recent work in behavioral finance has argued that some of the
The Prospect Theory (Utility) Value Function lessons we learn from violations of EU are central to understanding a
number of financial phenomena.”

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Some more prospects An odder example

• You must make two lottery choices. One draw will be in
• Prospect pair 5 – you are given $1000 – then choose between: morning; other in afternoon.
• A: (.5, another $1000)
• B: ($500) • Prospect pair 7:
• Prospect pair 6 – you are given $2000 – then choose between: • A: ($2400)
• A: (.5, -$1000) • B: (.25, $10,000)
• B: (-$500) Most people (84%) choose 7A.
• Results for 5: most prefer B. • Prospect pair 8:
• Results for 6: most prefer A. • A: (-$7500)
• Problems are identical! People have chosen differently • B: (.75, -$10,000)
because of different frames.
Most people (87%) prefer 8B.

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 An odder example (con’t.) An odder example (con’t.)
• But combining 7A and 8B leads to:
• Suppose now you have another prospect to decide. (0.25, $2400, -$7,600)  9A
• Prospect pair 9: • And combining 7B and 8A leads to:
• A: (0.25, $2,400, -$7,600) (0.25, $2500, -$7,500)  9B
• B: (0.25, $2,500, -$7,500)
• While 7B and 8A can be seen to be better than 7A and 8B
• (All) People choose 9B. when “framed” as 9B and 9A, most people do not see
through the opaque framing in the original two
decisions.
• Why? They have difficulty getting past frame.

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Another example: Framing with nonmonetary
outcomes
• Imagine that Thailand is preparing for the outbreak of an
unusual disease, which is expected to kill 1,000 people.
• Two alternative programmes, A and B, have been proposed to
combat the disease.
• (Survival Frame):
• If A is adopted, 250 people will be saved.
• If B is adopted, there is 25% that 1,000 will be saved, and
75% that no people will be saved.
• Which of the two programs do you choose?
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Another example: Framing with nonmonetary
outcomes
• Consider another situation  Imagine that Thailand is
preparing for the outbreak of an unusual disease, which is
expected to kill 1,000 people.
• Two alternative programmes, C and D, have been proposed to
combat the disease.
• (Mortality Frame):
• If C is adopted, 750 people will die.
• If D is adopted, there is 25% that nobody will die, and 75%
that 1,000 people will die.
• Which of the two programs do you choose?
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Another example: Framing with nonmonetary
outcomes
• (Note that A = C, and B = D).
• Of the respondents to the first problem (Survival Frame),
about 72% chose program A.
• People are risk averse for gains – lives saved are seen as
gains. The reference point here starts from full mortality.
• The second problem (Mortality Frame), 78% chose program
D.
• By contrast, they are risk seeking for losses – the current
reference point is that nobody has yet died (or full survival),
so any deaths are seen as losses.
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Mental accounting
• Related to prospect theory and frames.
• Mental accounting is the set of cognitive operations used
by individuals and households to organize, evaluate, and
keep track of financial activities.
– Expenditure accounts (foods, housing, entertainment),
Wealth account (checking account, retirement savings)
– Note that these “accounts” are mental constructs rather
than actual accounts.
• Mental accounting is beneficial.
– For example, it helps people exert self-control, encouraging
the use of rules such as “don’t dip into retirement savings”,
“pay for luxuries out of savings”.
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Another example: Framing with nonmonetary
outcomes
• The results are consistent with prospect theory.
• In other words, we again have loss aversion and framing
dependence.
• Therefore, in order to understand and model asset
prices or trading behaviour of investors, we need to
make some assumptions about investor preferences and
how investors make decisions under risky situations.
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Mental accounting
• However, often tendency to use mental accounting leads
to odd and suboptimal decisions.
• Traditionally, economists assume that funds are fungible
(substitutable). But, because of mental accounting, this
may not be so.
– Actual decisions people make indicate that money is not
always substitutable.
• A few highlights of mental accounting follow…
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 Theater ticket problems
1. Imagine you have decided to see a play where admission
is $10. As you enter theater you discover that you have lost
a $10 bill. Would you still pay $10 for a ticket to the play?
2. Imagine that you have decided to see a play and paid the
admission price of $10 per ticket. As you enter the theater
you discover that you have lost the ticket. The seat was not
marked and the ticket cannot be recovered. Would you pay
$10 for another ticket?
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Opening and closing accounts
• In the ticket problem, there was a natural time to close an
account. That is when the show is consumed.
• Once an account is closed, you go back to zero.
• Other accounts may, however, be somewhat more subtle, for
example, saving and investment accounts.
• Evidence that people avoid closing accounts at a loss:
• Selling a stock at a loss is painful: disposition effect (to be
further discussed).
• Companies rarely have low negative earnings but often
have low positive earnings:
• They manage earnings either pushing things to low
positive…
• Or they “take a bath” and move to high negative
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Theater ticket problems cont.
• Nothing is really different about the problems. However,……
– Of respondents given first question, 88% said they would buy
a ticket.
– Of respondents given second question, 54% said they would
not buy a ticket.
• In 1stquestion, the lost $10 bill is not directly linked to the ticket,
so people are willing to buy a new ticket.
• In 2nd question, when the ticket is originally purchased, a “ticket
purchase account” was set up, and would be closed after the
show ended.
• In 2nd question, therefore, the price of an additional ticket is
posted to the still open “ticket purchase account”, so the price of
a ticket is now seems to be $20, which many find to be too high
a price.
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Earnings Management to avoid losses
Burgstahler and Dichev 1997 “Earnings management to avoid earnings decreases and losses” Journal of Accounting
and Economics
Shen and Chih 2005 “Investor protection, prospect theory, and earnings management: an international comparison of
the banking industry” Journal of Banking and Finance 36
 The equity premium puzzles Historical (realized) equity premium in U.S.
• Historically, a well-diversified portfolio of stocks has
• Several big puzzles relate to aggregate stock market – substantially outperformed fixed income securities.
behavioral finance has partial explanations for some of
• Important to look at real returns which control for
these puzzles:
inflation effects.
• Difference between expected equity return and fixed-
• Equity premium puzzle: stock returns are higher than
income return is known as equity premium.
they should be given risk borne by investors in stock
markets – This is return for bearing additional risk of stocks
relative to bonds or bills
• What can explain this puzzle? Standard Expected Utility
Theory vs Prospect Theory…

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Total nominal return indexes: 1802-1997 Total real return indexes: 1802-1997

Siegel, J.J.. From "The Future Value of an 1802 Dollar Invested in Different Asset Classes (in nominal terms)," in Stocks for the Long Run 2nd Edition (McGraw Hill, New
York, New York), 1998. ©1998 by McGraw-Hill, Inc. All rights reserved. Reproduced by permission. Siegel, J.J.. From "The Future Value of an 1802 Dollar Invested in Different Asset Classes (in real terms)," in Stocks for the Long Run 2nd
Edition (McGraw Hill, New York, New York), 1998. © 1998 by McGraw-Hill, Inc. All rights reserved. Reproduced by permission.

©2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted39 ©2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or 40
to a publicly available website, in whole or in part. posted to a publicly available website, in whole or in part.
 Average historical real returns for Why is the equity risk premium puzzle?
stocks, bonds and bills • Stocks are riskier and therefore should earn higher
returns..
• But, the equity premium seems too high
• Theorists have shown that realized equity premium
implies an improbably large degree of risk aversion.
• First, In an economy with reasonable parameters,
average return on stock market would be just 0.1%
higher than risk-free rate, not 3.9% (or higher)
observed in most studies.
Siegel, J. J.. From "Average Real Returns (in %) on Stocks, Bonds and Bills," in Stocks for the Long Run, 2nd Edition, 1998 (McGraw Hill,
New York, New York). © 1998 by McGraw-Hill, Inc. All rights reserved. Reproduced by permission.

©2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted
to a publicly available website, in whole or in part.
41 42

Why is the equity risk premium puzzle? What can explain this equity premium puzzle?
• Second, based on a typical logarithmic utility function, • Benartzi and Thaler (1995) have linked prospect
the coefficient of relative risk aversion is 1.0. theory to equity premium puzzle.
• The coefficient of relative risk aversion needed to justify – Key is to remember loss aversion (investors hate losing
the observed equity risk premium would have to be a money) and mental accounting (consider how often
whopping 30 in order to explain observed returns! investors evaluate their portfolios)
• Third, recalling prospects and certainty equivalents, – Intuitively, if you evaluate your position every day, there is
consider the following prospect: a very good chance that by day’s end you will have lost
money, so you find stocks very risky and unattractive.
– P1(0.50, $50,000, $100,000)
– But if you evaluate stocks once per decade there is a much
– What certainty equivalent, $x, would make someone
smaller chance that you will lose money, so you will find
indifferent between P1 and this $x?
stocks not so risky. The loss aversion does not have much
– For someone with a coefficient of relative risk aversion of effect on you.
30, $x would need to be $51,209!!
Benartzi and Thaler (1995), Myopic loss aversion and the equity premium puzzle, the Quarterly Journal of
43 Economics, page 73-92 44
What can explain this equity premium puzzle?
• Loss aversion
– Benartzi and Thaler assume a loss aversion factor of 2.5.
– In other words, the loss of $1 is 2.5 times more painful
than a gain of $1 is pleasurable.
• Mental accounting
– Consider P(0.5, $200, $-100) as an investment where one
can make $200 or lose $100.
– The expected gain is $50, is the risk of the investment
worth the potential gain? Or should we just do nothing
rather than accept the prospect?
– V(P) = 0.50(200) + 0.50(2.5(-100)) = -25
– Reject the prospect!
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What can explain this equity premium puzzle?
• Mental accounting
– What if the prospect is allowed to be run twice before the
investor carefully notes the results?
– The possible outcomes for two gambles are $400 (with a
probability of 25%), $100 (with a probability of 50%), and
-$200 (with a probability of 25. We label it Px
– V(Px) = 0.25(400) + 0.50(100) + 0.25(2.5(-200)) = +25
– Note that now a loss is only half as likely (25% vs 50%) to
occur.
– While this person remains loss averse, she is now more
willing to take the risk of the investment as long as she
evaluate the outcomes two prospects at a time (i.e.,
looking at her portfolio every two periods).
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What can explain this equity premium puzzle?

• QUESTION: Given prospect theory approach, what

evaluation period is consistent with historically
observed market risk premium?
• ANSWER: About a year – which is logically how often
a typical investor gives his portfolio a careful look.
• Reasons:
– Tax is paid annually
– Portfolio assessment and adjustments are often annual
• Benartzi and Thaler refer to these loss aversion and short-
horizon portfolio evaluation as “myopic loss aversion”.

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