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Fred Viole OVVO Financial Systems fred.viole@ovvofinancialsystems.com

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David Nawrocki Villanova University Villanova School of Business 800 Lancaster Avenue Villanova, PA 19085 USA 610-519-4323 david.nawrocki@villanova.edu

An Analysis of Heterogeneous Utility Benchmarks in a Zero Return Environment

Abstract The utility of an investor should be based on an acceptable loss in the loss region and a target return in the gain region of a set of investment opportunities. The level of these benchmarks will unveil an opportunity cost, break-even effect, or indifference when the return of an investment equals zero. This condition has been arbitrarily assumed away for continuity and other simplification purposes over the last few decades. Historical utility functions, those that are von Neumann-Morgenstern compliant and not, are all constrained via a single target or reference point. This single target restriction coupled with the arbitrary zero-return assumption has ignored the important interpretation of this salient point on the utility curve as a proxy for the investor’s current wealth.

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I.

INTRODUCTION

We propose a utility function comprised of two autonomous functions: one function describing the utility of losses and one function describing the utility of gains. Each of these autonomous functions will be represented by a Markowitz Stochastic Dominance (MSD) Reverse-S curve per Levy and Levy (2002). We expand the notion of a dual target or multiple reference points as proposed in Lopes SP/A Theory (1987). Historically, with both von Neumann and Morgenstern compliant functions and not, a commonality is the single reference point or target. Our proposal better reflects the behavioral aspect of investing by incorporating an acceptable level of loss and an upside target. Moreover, the dissection of variance into upper (UPM) and lower (LPM) partial moments allows for the heterogeneous interpretations investors have towards above-target variances versus below target variances.

1. THE USE OF BENCHMARKS A valid utility function representing wealth over time should be governed by the simple axiom: utility is equal to a change in wealth with respect to an initial wealth condition. The formula representing this can be stated in Equation 1 as: U(Wt) = U(wt-1) + U(∆w) (1)

We cannot go back to zero wealth and track utility from the first change in wealth such as a birthday card from a relative or a summer job as a teen. We have to assume some level of initial wealth. There is a subjective interpretation that individuals have towards a nominal level of wealth (w). $1,000,000 may mean two different things to two different people. The amount of

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000. the winner.000 and they both have a level of wealth of $1.000 will simply mean more to Investor A as it represents a greater percentage of the PCS. while others will simply see it as inadequate to provide satiation.000.e.utility U(1. if Investor A has a PCS level of $5. Harry Markowitz notes in his 1952 work whereby he criticizes Friedman and Savage’s 1948 hypothesis. who is going to have a higher utility U(w)? The $1.000) will be reflected by how close that wealth is to their Personal Consumption Satiation level (PCS). There is nothing these men would prefer. rich and C. The amount of the bet would be (D – C)/2 half the size of the optimal lottery prize.000. We expect people to be repelled by such bets. 4|Page . At the flip of a coin the loser would become poor. Some individuals may feel content with that amount for a lifetime.000 while Investor B has a PCS level of $50. rather than one in which the loser would fall to C and the winner would rise to D. If such a bet were made.000. “Consider two men with wealth equal to C +1/2(D-C) (i. We do not observe persons of middle income taking large symmetric bets. will have identical symmetrical benchmarks for this wager (D. in the way of a fair bet. rich. Thus the benchmarks for this wager are a proxy for wealth and risk profiles. it is clear that both individuals along with identical wealth and risk profiles. poor). two men who are midway between C and D).” Upon investigation of this scenario. and thus will feel wealthier.000.. it would certainly be considered unusual and probably irrational. Not only would such a fair bet be acceptable to them but none would please them more. Any differences in interpretations of a given level of an identical wealth will solely be the result of different PCS benchmarks.000. This focuses our attention the benchmarks used in the computation of U(∆w). Example. Whether the two individuals are compelled to take such a wager is not relevant.

The difference between aggregate and per investment utility is the x-axis on the aggregate wealth function U(w) is lower bound by zero. Roy’s (1952) safety first level of subsistence. and a larger acceptable level of loss (LPM) compared to the LPM of decreased feeling of wealth.Markowitz (1952) centers his utility curve on a level of wealth that he describes as customary wealth. or current wealth U(w). 5|Page . Our curve is simply two Markowitz Stochastic Dominance (MSD) Reverse-S curves that meet at customary wealth (See Levy and Levy. one curve is centered on an upside target. Analysis of these benchmarks associated with an investment U(x) will be a valid proxy for effects on U(w) in the instance when x = 0 or no return. As explained in Viole and Nawrocki (2011). and the other curve centered on an acceptable level of loss. whereby the x-axis on the investment function U(x) is lower bound by the amount of the investment. 2002). Where we do differ is that our y-axis is the meeting point for both our autonomous loss and gain functions. the upside benchmark is the PCS and the lower benchmark is S. In the aggregate wealth function. an increased subjective wealth interpretation will be reflected via a relatively smaller upside benchmark (UPM) relative to the UPM of a decreased feeling of wealth. We do not differ as our y-axis is U(w). The MSD utility curve is also self-similar between the aggregate utility of wealth and the utility of an individual investment. Figure 1 illustrates the MSD utility curve.

Utility function consistent with Markowitz Stochastic Dominance 2. This avoids placing a weight or probability variable to the function which would only be additive to the inherent specification error. since that weight or probability is already reflected in the computation of the targets. 6|Page . yielding an optimal solution is not of concern. Whether they are ultimately right. A PROPOSED UTILITY FUNCTION USING UPM AND LPM Our function builds on a utility function by Holthausen (1981) by making a few assumptions: Assumption 1 The first assumption we make is that the investor has performed all of the necessary probability computations they require to accept their targets.Figure 1.

h is the target for computing below target returns. k is the loss aversion parameter and α is the curvature of the loss function. t is the single target from which Holthausen derives both utilities. and l is the target for computing above-target returns. q is the degree of the UPM. and β is the curvature of the gain function.Assumption 2 Our second assumption is there is no a priori reason to constrain subjective variance parameters. Rather the ratio of loss aversion exponent n and gainseeking exponent q will be able to replicate the loss aversion notion via n > q. By relaxing the constriction of Holthausen’s (1981) α and β in Equation 2 we do not need a constant k to generate loss aversion.z represents the returns of the investment x at time z. n is the degree of the LPM. “One major result derived in the paper is that the α – β – t model is congruent with a von Neumann-Morgenstern utility function of the form ( ) { ( ( ) ) (2) Where k is a positive constant and. With n and q > 1 7|Page . by construction U(t) = 0 and U(t+1) = 1” Holthausen (1981). Equations 3 and 4 representing the n-degree LPM and q-degree UPM: ( ) [∑ { } ] ( ) ( ) [∑ { } ] ( ) where Rx. x is the investment.

C and D. We have one MSD for gains. Assumption 3 The third assumption we make is if that target or reference point equals zero. This function is for an individual investment.we can also compensate for above-target risk-seeking behavior that eludes Holthausen due to β ≤ 1. 8|Page . In the aggregate utility of wealth U(w). In Markowitz’s example of his dual targets. the lower target is Roy’s Safety first level. serving as the reference point for that MSD Reverse-S function. U(x). or S. D – C = 0 because they are symmetrical. Thus the aggregated target gains minus losses equals zero. the upside target is the PCS from which a MSD ReverseS function will be centered on. In the loss region. For our model. centered on an acceptable level of loss. centered on an upside target and one MSD for losses. In Figure 2 below we have illustrated the complete function using Figure 1. n < q dictates overall risk seeking while supporting any nonlinear variance interpretations. the MSD Reverse-S function. it is a fair bet.

S level for aggregate wealth. PCS level for aggregate wealth.U(w) or customary wealth (dashed y-axis). concave .convex – concave – convex. revealing final shape of our function. MSD Reverse-S centered on acceptable level of loss Figure 2. MSD Reverse-S centered on upside target Acceptable loss for investment. LOSSES GAINS Upside target for investment. Superimposing 2 MSDs onto larger utility axes. 9|Page .

h.x) + U(0)) (UPM (q.y) > 0 If LPM (n.l.l. investment) n = Investor's loss aversion level q = Investor's gain-seeking appetite h = Target for computing LPM l = Target for computing UPM x = Investment y = Benchmark Y (Acceptable level of loss) a = Benchmark A (Upside target) 10 | P a g e .SINGLE BENCHMARK UPM / LPM UTILITY Figure 3.y.x) > 0 If LPM (n.x) – LPM (n.l.h.a) – LPM (q.a)) LPM Conditional Values If LPM (n.y) + UPM (n.l. ( – LPM (n.x) + U(0)) (UPM (q.x) = 0 UPM Conditional Values If UPM (q. Single Benchmark Utility Function.a) ≥ UPM (q.x) = 0 UPM ( ) = Upper partial moment (degree.x) > 0 If UPM (q. target.x) ≥ LPM (n. investment) LPM ( ) = Lower partial moment (degree.a.x) + UPM (q.a) > 0 If UPM (q.h.h.l.l.h.l.l.y) ≥ LPM (n. target.h.x) + U(0)) ( – LPM (n.y.x) ≥ UPM (q.h.a.h.y)) U(x) = (UPM (q.x) + U(0)) ( – LPM (n.

The next section of the paper will place our proposed utility model into the literature. The utility formula for an investment U(x) can be represented by the marginal change in wealth it produces. U(x) = U(∆w) (5) One would assume a zero return on an investment should produce no change in the aggregate utility of wealth. U(wt) = U(wt-1) + U(x) U(wt) = U(wt-1) + U(0) U(wt) = U(wt-1) (6) But. REVIEW OF THE LITERATURE It should be noted that a more extensive review of the literature is provided in Appendix A. and currently observed zero return investor behavior will follow. II. conclusions. Then we will explore the implications of the literature for our utility model. U(wt) = U(wt-1) + U(0) U(0) = U(wt) .U(wt-1) (7) 11 | P a g e . positive or negative. A short discussion. if we do not assume U(0) = 0 and isolate U(0) we have Equation 7 which illustrates that U(0) can be zero.

11U($1 M) < 0.01U($0 M) + 0.11U($1 M) U($0 M) ≤≥ 0 12 | P a g e . 10% chance of $5m 0. 1% chance of nothing U($1 M) > 0. 1953). negative.1U($5 M) -0. 11% chance of $1m SITUATION B 90% chance of nothing.01U($0 M) < 0.Using Allais’ paradox (Allais. EXPERIMENT 1 (Most participants choose A) SITUATION A $1m with certainty SITUATION B 89% chance of $1m.89U($1 M) + 0.9U($0 M) + 0. 10% chance of $5m.11U($1 M) U($0 M) < 0 EXPERIMENT 2 (Most participants choose B) SITUATION A 89% chance of nothing.1U($5 M) – 0.1U($5 M) – 0. we can show that U(0) does not equal zero when there is a certain outcome and can be zero.89U($0 M) + 0.1U($5 M) -0.01U($0 M) > 0. or positive when there is no certain outcome.

and it may take any value as per Fishburn and Kochenberger (1979): “This target point (Fishburn.What Allais’ decision examples isolate is the effect of the certainty equivalence and how it can rationally distort any expected value calculation. 1979) is often the zero-gain point. Post et al. 1960) or the gain region (Green. One consistency to note is that there is a single target or reference point. 1977 and Libby and Fishburn.” 13 | P a g e . 1979) will reveal what the utility interpretation is for a zero-return situation. (2008) note the Dutch contestants take a higher discount to expected value when the offer is a larger multiple of their annual income in an analysis of the gameshow Deal or No Deal. 1977) or reference point (Kahneman and Tversky. This observed behavior is completely consistent with risk aversion and a larger upside target of their local MSD for gains utility decisions. as in Markowitz’s (1952) case or in Swalm’s (1966) data. Table 2 summarizes these results derived in Appendix A. 1963). but it may be in the loss region (for some wildcatters as in Grayson. HISTORICAL UTILITY FUNCTIONS An examination of the historical utility functions that are compliant with von Neumann and Morgenstern (1947) as well as Prospect Theory (Kahneman and Tversky.

t is the target. c.u(k3(t – x0))/k4 for all x0 ≤ t where x0 is the investment. HOLTHAUSEN (1981) U(x) = (x – t)β U(x) = -k(t . FISHBURN (1977) U(x) = x for all x ≥ t U(x) = x – k (t – x)α for all x ≤ t where x is the investment.x)α for all x ≥ t for all x ≤ t where x is the investment. FISHBURN AND KOCHENBERGER (1979) U(x0) = u0 + u(k1(x0 – t))/k2 for all x0 ≥ t U(x0) = u0 .a. k3 and k4 are the loss aversion parameters. t is the target. t is the target. k is the loss aversion parameter and α is the curvature of the loss function. and β is the curvature of the gain function. b. k is the loss aversion parameter and α is the curvature of the loss function. u0 is the utility function in the original data format. k1 and k2 are the gain-seeking parameters. 14 | P a g e .

Comparison of U(0) and benchmark scenarios U(0) Positive Benchmark Negative Benchmark Zero Benchmark (Fair Bet) Fishburn* Negative 0 0 Fishburn and Prospect Holthausen* Kochenberger*§ Theory 0 Negative Negative 0 0 DNE 0 DNE 0 (*) von Neumann-Morgenstern (1947) compliant (§) U(0) = 0 forced assumption (DNE) Does not exist 15 | P a g e . is the loss aversion parameter and α is both the curvature of the loss function and the gain function. Table 2. RP is the reference point. PROSPECT THEORY – KAHNEMAN AND TVERSKY (1979) ( ( ) ) ( | ) { where x is the investment.d.

By identifying an acceptable level of loss and an upside target (akin to C and D per Markowitz. such as that in Figure 1 for example. The zero and unit of the utility scale. the rest of the utility curve follows from the individual's preferences.” The logic behind this observation is provided by Markowitz (1959): "In general. once the zero and unit of the utility scale are chosen. A risk-averse investor should exhibit a form of relief or positive utility from a zero return. or something as temporal as a stop loss and a limit order investors typically use). It is shown in the footnote that. if a risk-averse investor's first goal is to not lose. isn’t the first goal of risk aversion not to lose? Furthermore. U(0) INTERPRETATIONS AND FURTHER DEVELOPMENT One possible explanation for the negative utility generated from a zero return is opportunity cost. therefore. any better outcome can be assigned utility equal to one. the level of return with zero utility and the (higher) level of return with unit utility can be chosen arbitrarily. rather than arbitrarily set the wealth benchmark at zero or one.III. Markowitz (2010) notes this notion. 1952." The single target or reference point is one major hindrance in reflecting a level of wealth. On a utility curve. However. “Because not buying the ticket has a utility U(0) = 1. 16 | P a g e . No more points may be arbitrarily selected without affecting the preferences represented by the curve. any outcome can be assigned utility equal to zero. doesn't a zero return satisfy that goal? Then why would an investor realize a negative utility from such an event? Opportunity cost would be more aligned with a risk-seeking investor. we avoid this hindrance and are able to let the individual preferences of the function generate both negative and positive levels of utility for a zero return under different wealth benchmark configurations. is a matter of convention and convenience. consistent with a break-even effect.

Upside target = acceptable level of loss. If y (acceptable level of loss) = a (upside return target). 80 60 Upside Target 40 Acceptable level of loss 20 UTILITY Lower Partial Moment Upper Partial Moment 0 -20 -40 -60 -80 0 2 4 6 -8 -6 -4 LOSSES -2 GAINS 8 Figure 4.l. When LPM(n. U(0) = -LPM(n. indifference loss exponent ratio) then. Symmetrical benchmarks. U(0) = 0. SYMMETRICAL BENCHMARKS For a zero return x = 0.x) = 0 Then our utility function reduces to.h.y) + UPM(q.x) = 0 and UPM (q.l. this situation would infer that there would be no UPM or LPM.h.a). h (target to compute lower partial moment from) = l (target to compute upper partial moment from) and n (loss aversion exponent) = q (risk-seeking exponent) (symmetrical benchmarks from the same target [does not have to be 0 as for nominal gains and losses]. 17 | P a g e .1.

The function is continuous when U(0) = 0. But what about an opportunity cost? 18 | P a g e . This symmetrical benchmark setup represents a fair bet to the investor. This makes sense considering a zero return and indifference of the investor. The local investment U(0) = 0 or no change in wealth from the investment. will not affect the aggregate level of overall utility. utility. intersects the y-axis. at 0.The symmetrical inflection points at benchmarks y and a (C and D respectively per Markowitz 1952).

indifference loss exponent ratio) then U(0) = -LPM(n.2. 100 80 60 40 20 UTILITY 0 -20 -40 -60 -80 0 2 4 6 -8 -6 -4 LOSSES -2 GAINS 8 Acceptable level of loss Upside Target Lower Partial Moment Upper Partial Moment Figure 5. Upside target < acceptable level of loss.l.a) U(0) = negative or U(0) < 0 The LPM will be larger than the UPM generating a negative utility from a zero return reflecting the opportunity cost. ASYMMETRICAL BENCHMARKS: INCREASED WEALTH If y > a. Asymmetrical benchmarks reflecting increased wealth. h = l and n = q (asymmetrical benchmarks from the same target. No change in wealth from a zero return lowers the aggregate utility of overall wealth due to the opportunity cost of that investment as illustrated in Figure 5.h. y) + UPM(q. 19 | P a g e . This is a function of the asymmetrical benchmarks identified with an increased wealth applied to an investment.

The opportunity cost is also additive.This opportunity cost can be viewed as the intersection of the y-axis at a negative utility point for the loss function. The amount of the discontinuity at U(0) equals opportunity cost when the acceptable level of loss is greater than the upside target. it is experienced for all losses where x < 0. 20 | P a g e .

indifference loss exponent ratio) then. U(0) = -LPM(n.y) + UPM(q. 21 | P a g e . 80 60 40 20 UTILITY Lower Partial Moment Upside Target Acceptable level of loss 0 Upper Partial Moment -20 -40 -60 -80 -100 0 2 4 6 -8 -6 -4 LOSSES -2 GAINS 8 Figure 6. Asymmetrical benchmarks reflecting decreased wealth.a) U(0) = positive or U(0) > 0 The UPM will be larger than the LPM generating a positive utility from a zero return reflecting the relief a less wealthy individual experiences from a break-even effect as shown in a decreased UPM target and an increased LPM acceptable level of loss in Figure 6. and n = q (asymmetrical benchmarks from the same target. Upside target > acceptable level of loss. h = l. ASYMMETRICAL BENCHMARKS: DECREASED WEALTH If a > y.l.h.3. A no change in wealth raises the aggregate utility of overall wealth due to the break-even effect of that investment.

Concavity of gains is also used to reinforce the notion of risk aversion. the associated benchmarks as described earlier will be shifted to reflect this aversion. Second. On the upside. convexity of gains is less of a concern than forcing concavity in a bid to address an absurd prior assumption of infinite monetary resources. this convexity was ultimately concave to put a boundary on the yaxis. by assuming there is some finite level of wealth that can be ascribed to an asset. We avoid the paradox by putting a boundary on the x-axis. First.This break-even effect can be viewed as the intersection of the y-axis at a positive utility point for the gain function. EVIDENCE OF REVERSE-S UTILITY CURVES One need only identify the notion of risk seeking with gains to provide an argument for convexity of gain functions. not by concavity. The break-even effect is also additive. In order to not violate the St. the ratio of the loss-seeking exponent versus the gain-seeking exponent (n:q) will be greater than one for a risk-averse investor. while the downside boundary is zero wealth or bankruptcy. The amount of the discontinuity at U(0) = break-even effect when the acceptable level of loss is less than the upside target. such as greed in a risk-averse manner. but multiple other methods. it is experienced for all gains where x > 0. Petersburg Paradox. as noted in Figure 7 (in Appendix A) from Viole and Nawrocki (2011). the ultimate utility boundary is the total amount of monetary assets available in circulation. we are also able to demonstrate overall risk aversion. 4. Since utils are subjective units of measure. However. This flexibility and asymmetry is far superior to the rigidity of historical functions when being applied to complex human behavior. 22 | P a g e . originally proposed by Markowitz (1952).

Another example of human behavior that confounds historical functions is philanthropy. Fishburn and Kochenberger (1979) note a similar discontinuity at U(0) with their two-piece von Neumann-Morgenstern utility function. getting happier. To properly reflect a break-even effect (positive utility for a zero return). In this sense. The unintended consequence from this action is positive utility readings from losses. “To the first point. the utility derived from helping others is intangible. and from E+ when b1 = k and b2 goes to infinity. such that happiness and giving may operate in a positive feedback loop (with happier people giving more. This discontinuity is critical in avoiding a major philosophical discrepancy arising from shifting a continuous curve along the y-axis. amplified by the amount of break-even effect and underlying curve characteristics. This arises from P+ when a1 = k and a2 goes to zero. 2009).” 23 | P a g e . the evidence we reviewed is quite supportive: Happier people give more and giving makes people happier. and giving even more)” (Anik. The discontinuity at one specific point. “Finally. the continuous function would have to be shifted upwards to intersect the y-axis at this positive point. Under no circumstances could a nominal loss be viewed as a positive utility generator in our function. Aknin. zero. we note that P+ and E+ have a limiting form that is discontinuous at the origin with U(0) = 0 and U(x) = k for all x > 0. 5. This intangible utility is also better governed by an economies-of-scale convex function rather than the assumed concavity to represent the positive feedback experienced. DISCONTINUITY OF THE UTILITY FUNCTION We note how the function is discontinuous under any asymmetry of benchmarks. Norton and Dunn. ensures this critical notion is upheld with our loss function upper bound by zero and our gain function lower bound by zero.

CONCLUSIONS How can a zero change in wealth offer different utility values? The intransitive nature of a utility observation at time z means that even if Xz = Xz-1 they can have wildly different interpretations due to the shift in either a UPM or LPM benchmark.” Fishburn and Kochenberger (1979) also note the influence of a target point. We shall refer to t as the target point although we do not know with certainty that it served as a conscious “target level” for the individuals concerned. either as indifferent. essentially emulating a wealthier individual’s preferences. (2008) note this. One important distinction is that the lower upside benchmark (UPM) / larger acceptable level of loss (LPM) can capture risk seeking from a less wealthy individual. In a zero return scenario we can examine how the benchmarks reflect this investment result. 24 | P a g e . Thus.” We have identified how the heterogeneous benchmarks drive U(∆w) and we have noted how they are influenced by the individual’s subjective wealth interpretation. Post et al. there is usually a point t on the abscissa at which something unusual happens to the individual’s utility function. “First. knowing the initial wealth level cannot provide the insight to the risk profile that the benchmarks reveal. “The specification of the subjective reference point (or the underlying set of expectations) and how it varies during the game is crucial for our analysis.IV. Risk-averse investors can become risk-seeking investors by emulating targets and acceptable levels of loss from someone wealthier. an opportunity cost or a relief. as it determines whether outcomes enter as a gain or a loss in the value function and with what magnitude. forcing them to be bigger risk seekers than their wealth level would rationally infer.

x) (UPM (q.y. This information cannot be derived from a level of wealth (w). we are witnessing the same actions by the banks themselves with their record deposits of excess reserves at the Federal Reserve yielding zero. Thus. the utility realized from a zero return will be negative (representing an opportunity cost) or positive (representing a breakeven effect).y) ( – LPM (n.h.x) + + U(0)) U(0)) LPM Conditional Values If LPM (n. U(wt-1) ( – LPM (n. This is fully consistent with a risk-averse.h.l.l.x) = 0 Anecdotally.x) ≥ LPM (n.Only in the instance of a fair bet does U(0) = 0.l.a)) – + LPM (q.a.l.x) = 0 – + U(∆w) Opportunity Cost LPM (n. since their actions are clearly maximizing their expected utility.y) ≥ LPM (n.h. we are currently witnessing this break-even effect phenomenon with individual participant cash deposits at banks yielding zero.x) UPM (q.a) (UPM (q.l.x) > 0 If LPM (n.h.y. Furthermore.h.x) Break-Even Effect + + U(0)) U(0)) UPM Conditional Values If UPM (q.l.h.h. Under any asymmetry.x) > 0 If UPM (q.x) ≥ UPM (q.a) ≥ UPM (q.x) (– LPM (n.a.l. generating a positive utility. it is only under an inspection of the benchmarks associated with that level of wealth and a zero return that we can better understand U(w). 25 | P a g e .y)) U(w) = (UPM (q.a) > 0 If UPM (q.x) UPM (n.h. decreased feeling of wealth for an investment generating the positive utility break-even effect for a zero investment return.l.y) > 0 If LPM (n. Thus it can be inferred that the aggregated target or reference point these participants are using for this investment is negative.

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28 | P a g e .APPENDIX A: U(0) RESULTS FOR HISTORICAL UTILITY FUNCTIONS A. U(0) < 0 for all t > 0.k (t)α A 0 return will then generate a negative utility with a more negative result for the more riskaverse investor (higher k).1 FISHBURN (1977) U(x) = x for all x ≥ t U(x) = x – k (t – x)α for all x ≤ t Fishburn 0 Return below a POSITIVE Target U(x) = x – k (t – x)α for all x ≤ t U(0) = 0 – k (t – 0)α U(0) = . Fishburn 0 Return above a NEGATIVE Target U(x) = x U(0) = 0 for all x ≥ t A 0 return will always generate a 0 utility given t ≤ 0.

29 | P a g e .Fishburn 0 Return and a 0 Target U(x) = x for all x ≥ t U(x) = x – k (t – x)α for all x ≤ t U(x) = x U(0) = 0 U(x) = x – k (t – x)α for all x ≤ t U(0) = 0 – k (0 – 0)α U(0) = 0 for all x ≥ t If t= 0 and x = 0 then both utilities are valid. t = 0 however. Thus U(0) = 0. infers a fair bet that would be unusual and probably irrational for the investor.

but best two-piece fits with the forms used here would require a simultaneous below-above fit.” 30 | P a g e . however..A. since we felt that the separately fit pieces were adequate to examine the issues raised in the introduction. by using cx + d instead of cx for the linear fits – but the U(0) = 0 constraint for all functions above and below target ensures the continuity of each two-piece utility function at the target. since it forces the function to pass through the indicated point.g. Continuity at t could also be ensured without forcing u(0) to equal zero. limits the goodness of fit. a function that can have both convex and concave segments). We did not do this. or U(t) = u0.2 FISHBURN AND KOCHENBERGER (1979) U(x0) = u0 + u(k1(x0 – t))/k2 for all x0 ≥ t U(x0) = u0 . One might also fit a single function through all the data points (e.u(k3(t – x0))/k4 for all x0 ≤ t Fishburn and Kochenberger (1979) force U(0) = 0 and explain the rationale as follows: “The restriction of U(0) = 0. Better overall fits could be obtained by not requiring U(0) to equal zero – for example.

U(0) is negative.3 HOLTHAUSEN (1981) U(x) = (x – t)β U(x) = -k(t . 31 | P a g e .” Holthausen 0 Return above a NEGATIVE Target U(x) = (x – t)β U(0) = (0 – t)β U(0) = (-t)β for all x ≥ t This is interesting. This is consistent with Fishburn (1977) and Holthausen’s goal of consistency (1981). Not only can this not be computed (a negative number to a root exponent) but in the instance of β = 1. the decision maker is risk-averse (risk neutral)(risk seeking) for payoffs above the target. if β is less than (equal to) (greater than) one. If we take the liberty to relax the β constriction per Holthausen (1981) “Similarly. Holthausen limits his β ≤ 1 to force compliance with first.” .A. U(0) will alternate between positive and negative when β is even or odd respectively. “The purpose of this paper is to present a risk-return model that has many of the same attributes as Fishburn’s model. and thirddegree stochastic dominance.x)α for all x ≥ t for all x ≤ t Holthausen 0 Return below a POSITIVE Target U(x) = -k(t-x)α U(0) = -k(t – 0)α U(0) = -k(t)α for all x ≤ t A 0 return will then generate a negative utility with a more negative result for the more riskaverse investor (higher k). U(0) < 0 for all t > 0. then as β > 1. but one in which the utility function for above-target outcomes need not be linear. second.

Holthausen 0 Return and a 0 Target U(x) = (x – t)β U(x) = -k(t . Thus U(0) = 0. “One major result derived in the paper is that the α – β – t model is congruent with a von Neumann-Morgenstern utility function of the form ( ) { ( ( ) ) Where k is a positive constant and. t = 0. however.” 32 | P a g e . infers a fair bet that would be unusual and probably irrational for the investor. not in the context of a U(0) when x ≠ t. Holthausen (1981) handles U(0) only when x = t.x)α for all x ≥ t for all x ≤ t U(x) = (x – t)β U(0) = (0 – 0)β U(0) = 0 U(x) = -k(t . by construction U(t) = 0 and U(t+1) = 1.x)α U(0) = -k(0 – 0)α U(0) = 0 for all x ≥ t for all x ≤ t If t= 0 and x = 0 then both utilities are valid.

x)α for x ≤ RP v(x|RP) = -λ(RP . 33 | P a g e .x)α for x ≤ RP v(0|0) = -λ(0 . Prospect Theory 0 Return above a NEGATIVE Reference Point v(x|RP) = (x – RP)α v(0|RP) = (0 – RP)α v(0|RP) = (– RP)α for x > RP This cannot be computed (a negative number to a root exponent). U(0) < 0 for all RP > 0. Thus U(0) = 0 under a fair bet scenario for Prospect Theory as well.88 in Prospect Theory to reflect the concavity of gains.4 PROSPECT THEORY – Kahneman and Tversky (1979) ( | ) { ( ( ) ) Prospect Theory 0 Return below a POSITIVE Reference Point v(x|RP) = -λ(RP . Prospect Theory 0 Return and a 0 Reference Point v(x|RP) = -λ(RP .0)α v(0|0) = 0 Only in the loss function can x = RP = 0.A.0)α v(0|RP) = -λ(RP)α A 0 return will then generate a negative utility with a more negative result for the more riskaverse investor (higher λ). Unless α ≥ 1. a 0 result above a negative target (such as the S&P 500 in a losing period) does not exist.x)α for x ≤ RP v(0|RP) = -λ(RP . α = 0.

LPM and UPM will shift left representing an increased ability / propensity to gamble “house money effect”.5 7 UTILITY -20 -40 -60 -80 -100 34 | P a g e . 1952 subsistence level S) as well as the increased amount to reach personal consumption satiation (PCS).5 0.5 2. 6.5 1. Increased wealth effect on singularity utility model As overall wealth increases (blue function).5 5. illustrating the increased effect of any losses to a poorer individual as it is closer to encroaching upon their basic necessities (Roy's.5 2.5 1.WEALTH EFFECT ON SINGULARITY UTILITY 80 60 40 20 0 7 6 5 4 3 2 1 0 1 2 3 4 5 6 6.5 0. A decreased overall wealth (red function) will shift LPM and UPM to the right.5 4.5 3. reducing the certainty equivalence for UPM. Downside tolerances are also increased highlighting the effect of accumulated wealth on the investor's core subsistence level.5 LOSSES GAINS Figure 7.5 4.5 5.5 3.

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UsefulNot useful- The Utility of Wealth in an Upper and Lower Partial Moment Fabricby OVVOFinancialSystems
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