A survey

Problem 1:
Imagine that you face the following pair of concurrent decisions.
First examine both decisions, and then indicate the options you
prefer.
Decision (i). Choose between:
(A) a sure gain of Rs.240
(B) 25% chance to gain Rs.1,000, and 75% chance to gain nothing
Decision (ii). Choose between:
(C) a sure loss of Rs.750
(D) 75% chance to lose Rs.1,000, and 25% chance to lose nothing

(A&D-60%)
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Problem 2:
Decision (i).
Assume yourself richer by Rs.300 than you are today. You have
to choose between
(A) a sure gain of Rs.100 and
(B) a 50% chance to gain Rs.200 and a 50% chance to gain
nothing.
Decision (ii). Assume yourself richer by Rs.500 than you are
today. You have to choose between
(C) a sure loss of Rs.100 and
(D) a 50% chance to lose nothing and a 50% chance to lose
Rs.200.

(B&D- 65%)
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Problem 3(Lottery):
Choose between two prospects, A and B:
(A) 1 in 1,000 chance of getting Rs.5,000
(B) a sure gain of Rs.5

(A-66.7%)

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Problem 4 (Insurance):
Choose between two prospects, A and B:
(A) 1 in 1,000 chance of losing Rs.5,000
(B) a sure loss of Rs.5(MAJORITY-57%)

Problem 5:
Decision (i). Choose between two prospects, A and B:
(A) 80% chance of getting Rs.4,000
(B) a sure gain of Rs.3,000
Decision (ii). Choose between two prospects, C and D:
(C) 20% chance of getting Rs.4,000
(D) 25% chance of getting Rs.3,000

(B&D-53%)
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Problem 6:
Decision (i). Choose between two prospects, A and B:
(A) 45% chance of getting Rs.6,000
(B) 90% chance of getting Rs.3,000
Decision (ii). Choose between two prospects, C and D:
(C)0.1% chance of getting Rs.6,000
(D)0.2% chance of getting Rs.3,000

(B&C-67%)

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Problem 7(Survival frame):
Imagine that India is preparing for the outbreak of
Monkeypox, which is expected to kill 600 people. Two
alternative programs to combat the disease have been
proposed. Assume that the exact scientific estimates of the
consequences of the programs are as follows:
If Program A is adopted, 200 people will be saved.If Program B
is adopted, there is a 1/3 probability that 600 people will be
saved, and a 2/3 probability that no people will be
saved.Which of the two programs would you favor?MAJORITY
A-87%

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Problem 8(Mortality frame):
Imagine that India is preparing for the outbreak of next
variant of covid, which is expected to kill 600 people. Two
alternative programs to combat the disease have been
proposed. Assume that the exact scientific estimates of the
consequences of the programs are as follows:
If Program C is adopted 400 people will die.If program D is
adopted that is a 1/3 probability that nobody will die, and a
2/3 probability that 600 people will die.Which of the two
programs do you favor?
MAJORITY D-67%

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Problem 9:
Imagine that you have decided to see a play at Prithvi
Theater where admission is Rs.500 per ticket. As you enter the
theater you discover that you have lost a Rs.500 note. Would
you still pay Rs.500 for a ticket to the play? YES-80%

Problem 10:
Imagine that you have decided to see a movie at PVR
INOX and paid the price of Rs.350 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
Rs.350 for another ticket?NO-62%

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Prospect Theory, Framing and Mental
Accounting

Session 4 & 5
Expected Utility Theory Psychology
• Rationality • Partial Rationality
• Selfishness • Partial Selfish
• Stable Tastes • Tastes do change

• Artificial Intelligence • Natural Stupidity

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 Prospect theory
• Prospect theory was developed by Kahneman
and Tversky base on observing actual behavior.
• Experimental evidence says that people
often behave contrary to expected utility
theory.
• Expected utility theory is normative.
– What people should do
• While prospect theory is positive.
– What people do
 Your View
• Today Ram and Shyam have a wealth of Rs. 10 million.
Yesterday Ram had Rs. 5 Million and Shyam had Rs. 15
million. Is their happiness same? Do they have same
utility?

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 One more

• Ravi’s current wealth is Rs. 2 million Geeta’s

current wealth is Rs. 5 million.
• Both of them are offered a choice between a
gamble and sure thing, in lieu of their current
wealth, and they have to opt for one of them.
• Gamble : 2 equiprobable outcomes: Rs. 2
million or Rs. 5 million
• Sure Thing: Rs. 3 million

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 Risk aversion vs. risk seeking
• Prospect pair 1 -- choose between:
– A: (.8, 4,000)
– B: (3,000)
– Note: with certainty no need to show a probability
• Prospect pair 2 – choose between:
– A: (.8, -4,000)
– B: (-3,000)
• Results for 1: most prefer sure Rs.3000 which is consistent
with risk aversion.
• Results for 2: most do not prefer sure -Rs.3000 – this is
inconsistent with risk aversion.
• Implies people are risk seeking in negative domain (reflection
effect)!
 Loss aversion
• Prospect pair 3 -- choose between:
– A: no prospect
– B: (.5, Rs.50, -Rs.50)
• Most choose A.
• Despite risk aversion in positive domain and risk
seeking in negative domain, losses loom larger than
gains.
• This is called loss aversion.
 Development of prospect theory

– These and other results led to prospect theory as an

alternative to expected utility theory.
– Key precepts:
• Value function is in terms of gains or losses
• Risk aversion in positive domain
• Risk seeking in negative domain
• Loss aversion
 Key Tenets of Prospect Theory

• Reference Dependence
• Diminishing Sensitivity
• Loss Aversion
• Changes is Risk Attitude
• Decision Weights

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 Reference Dependence

• Decision 1: You are richer by Rs. 3000 than

you are today, and then choose between
P1(1000) and P2(0.50,2000)

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 Reference Dependence

• Decision 2: You are richer by Rs. 5000 than

you are today, and then choose between
P3(-1000) and P4(0.50,2000)

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 Reference Dependence

• Reference point is important for decision

making and not the wealth generated alone
• Reference point in decision making is current
wealth.
• Reference dependence is ubiquitous in
sensation and perception
• Same sound will experience as loud or aint
depending on whether it is preceded by a
whisper or a roar.
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 Diminishing Sensitivity

• People value Gain/loss according to following

function Value

Losses Gains
Reference Point

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 Diminishing Sensitivity
• Concave for Gains
- People feel good when they gain but twice the
gain??
- Risk Averse
• Convex for losses
- People feel pain when they lose but twice the
gain??
- Risk Seeking
 Loss Aversion

• Feel more strongly about pain from loss rather

than pleasure form equal gain.
• Hence Loss Averse
• Prospect P1(0.5,-1000,1100) or P2(0)
• Brain give priority to bad news than good
news- Better safe than sorry
• Diminishing returns for good things but
exponential ones for bad things
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 Changes in Risk Attitude

• Decision 1: P5(2400) or P6(0.25,10000)

• Decision 2: P7(-7500) or P8(0.75,-10000)

• As situations change, the risk attitude of

people is not same and hence not fully
rational

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 Decision weights

• People weight outcomes by Transformed

probabilities(π) (or decision weights) and not
by objective probabilities(p)
weight
s

Probability 26
 Decision Weights

• Weighting function overweight low

probabilities and underweight high
probabilities
• People prefer both lotteries and insurance
• People prefer a 0.001 chance of winning
10000 to certain 10 and also a certain loss of
10 to a 0.001 chance of losing 10000

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Common value function functional form
– Function used often is:
v(z) = zα for z≥0, 0<α<1
v(z) = -λ(-z)β for z<0, l>1, 0<β<1
– Kink at origin is from λ.
– Value function (not utility) so v is used.
– Ask people about 50/50 coin toss where loss is Rs.50 and gain is
unknown.
– On the basis of empirical research both α and βare estimated as
0.88 and λ as 2.25
– What gain would make people indifferent between gamble or
no gamble?
• Many say about Rs.125, which implies value of 2.5 for λ.
• Value above one reflects loss aversion.
 Certainty effect
• Prospect pair 8 -- choose between:
– A: (.2, Rs.4000)
– B: (.25, Rs.3000)
• Prospect pair 9 – choose between:
– A: (.8, Rs.4,000)
– B: (Rs.3000)
• Most choose 8A and 9B, but they shouldn’t.
– Use exact same proof as above
• Why?
– Certainty is accorded high weight relative to near-certainty
 Weighting function notes
• Instead of using simple probabilities as in expected utility,
prospect theory uses decision weights, which differ from
probabilities.
• This (displayed) mathematical function is:

p(pr) = prg / [prg + (1- pr)g](1/g) where g = .65

• Weighting function for losses can vary from weighting

function for gains.
• Low probabilities are given relatively higher weights than
more probable events.
• And certainty is weighted highly vs. near-certainty.
• Using functions like this solves some earlier puzzles.
Valuing prospects under prospect theory
• Instead of expected utility we have:
V(P) = p(pr A) * v(zA) + p(1 - prA) * v(zB)
• Steps:
– Convert probabilities to decision weights
– Calculate values of wealth differences
– Use above formula
 Prospects 8 & 9 again
• Following probabilities are mapped on to this
weighting function:
– pr = .20; p =.26
– pr = .25; p =.29
– pr = .80; p =.64
– pr = 1; p = 1
• Say we use v(z) = z1/2.
• Prospect 8:
– A: .26*40001/2 = 16.44
– B: .29*30001/2 = 15.88
– A is preferred.
 Prospects 8 & 9 again cont.

• Prospect 9:
– A: .64*40001/2 = 40.48
– B: 1*30001/2 = 54.78
– B is preferred.
– A vs. B flip-flop comes from weighting function.
 Four-Fold Pattern of Preferences

Gains Losses
High Probability ( Certainty 95% chance to win 95% chance to lose
Effect) 1000000 1000000
Fear of Disappointment Risk Seeking
Risk Averse Reject Favorable
Accept unfavorable settlement
settlement
Low Probability (Possibility 5% chance to win 1000000 5% chance to lose 1000000
Effect) Hope of large gain Fear of Large loss
Risk Seeking Risk Averse
Reject Favorable Accept unfavorable
settlement settlement
Lottery Ticket Insurance

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 Investor Profile

• Dilip has the following value function under prospects theory:

v(w)=w0.8 if w≥0
v(w)=-2(-w)0.5 if w<0

a. Is Dilip Loss Averse?

b. Assume that Dilip wieghts values by probabilities. Which of
the following prospects would he prefer?
P1(0.6,8000,-5000)
P2(0.7,6000,-2000)

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 Blind Spots in Prospect Theory

• Reference point, usually status quo, has a

value of 0.
• Following gambles:
- A: One chance in million to win 1 million
- B: 90% chance to win 12 and 10% to win
nothing
- 90% chance to win 1 million and 10% to win
nothing
• Possibility of Regret 36
 Frames
• Essential condition for a theory of choice is
principle of invariance: different
representations of same problem should yield
same preference.
• Unfortunately this sometimes does not work
out in practice:
– People have different perspectives and come up
with different decisions depending on how a
problem is framed.
Problem… Swine flue attacks again

• Estimated that 6000 people would die.

• Programme A: Develop a vaccine which can
save 2000 people
• Programme B: Develop a vaccine which will
stop anyone form dying provided it works.
Probability that it will work is one third. If it
doesn’t work no one would be cured.

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 Some more solutions

• Programme C: Accept that 4000 victims would

die
• Programme D: Cure all 6000 victims with a
probability of 1/3

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 An odder example
• You must make two lottery choices. One draw will be in
morning; other in a`ernoon.
• Prospect pair 12:
– A: (Rs.2400)
– B: (.25, Rs.10,000)
• Prospect pair 13:
– A: (-Rs.7500)
– B: (.75, -Rs.10,000)
• People prefer 12A and 13B.
 An odder example cont.
• But 12A and 13B combo leads:
(.25, Rs.2400, -Rs.7,600)
• And 12B and 13A combo leads:
(.25, Rs.2500, -Rs.7,500)
• So people on average choose a gamble that is
dominated by the one that they turn down.
• Why? They have difficulty getting past frame.
 Mental accounting

• Related to prospect theory and frames.

• Accounting is process of categorizing money,
spending and financial events.
• Mental accounting is a description of way people
intuitively do these things, and how it impacts
financial decision-making.
• Often tendency to use mental accounting leads
to odd and suboptimal decisions.
• A few highlights of mental accounting follow…
 Mental accounting

• Once outcome is assigned to mental account,

it is difficult to view in another way.
• Mr. & Mrs. Sharma have saved 10 lakh for
their daughter’s wedding that may take place
3 years form now. The money earns interest
of 9% in FD. They just bought a new car for 6
lakhs which they have taken on a 3 year car
loan at 12%.

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 Mental Budgeting

• A purchase of Clothes washer and Dryer

costing 12000
• Option A: Six, monthly payments of 2000 each
before the arrival of washer and dryer
• Option B: Six, monthly payments of 2000 each
during the six months beginning a`er the
arrival of washer and dryer

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 Mental Budgeting

• A one week vacation costing 12000

• Option A: Monthly payments of 2000 each
during the six months prior to vacation
• Option B: Monthly payments of 2000 each
during the six months beginning a`er the
vacation

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 Prospect theory, mental accounting
and prior outcomes
• Problem with prospect theory is that it was
set up to deal with one-shot gambles – but
what if there have been prior gains or losses?
• Do we go back to zero (segregation), or move
along curve (integration)?
Integration vs. segregation

Integration

Segregation
 Opening and closing accounts

• Once an “account” is closed, you go back to

zero.
• Evidence that people avoid closing accounts at
a loss:
– Selling a stock at a loss is painful: disposition effect (to be
discussed).
– Companies rarely have low negative earnings but o`en have
low positive earnings:
• They manage earnings either pushing things to low positive…
• Or they “take a bath” and move to high negative
 Mental Accounting and Investing

• Adverse Impact
• Disposition effect: Sell the winner and Ride
the loser
• Segregating portfolio in different mental
accounts

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