Prospect theory and stock market premium

Q.1: Describe how prospect theory is explaining the preferences of investors in contrast to the
expected utility theory
Common sense might suggest that individuals combine the net effect of the gains and the losses
associated with any choice in order to make an educated evaluation of whether that choice is
desirable. An academic way of viewing this is through the concept of “utility,” often used to
describe enjoyment or desirability; it seems logical that we should prefer those decisions which
we believe will maximize utility.
On the contrary, though, research has shown that individuals don’t necessarily process
information in such a rational way. In 1979, behavioral finance founders Kahneman and Tversky
presented a concept called prospect theory. Prospect theory holds that people tend to value
gains and losses differently from one another, and, as a result, will base decisions on perceived
gains rather than on perceived losses. For that reason, a person faced with two equal choices
that are presented differently (one in terms of possible gains and one in terms of possible
losses) is likely to choose the one suggesting gains, even if the two choices yield the same end
result.
Prospect theory suggests that losses hit us harder. There is a greater emotional impact
associated with a loss than with an equivalent gain.
Evidence for Irrational Behavior
Kahneman and Tversky engaged in a series of studies in their work toward developing prospect
theory. Subjects were asked questions involving making judgments between two monetary
decisions that involved potential gains and losses. Here is an example of two questions used in
the study:
1. You have $1,000 and you must pick one of the following choices:
Choice A: You have a 50% chance of gaining $1,000, and a $50 chance of gaining $0.
Choice B: You have a 100% chance of gaining $500.
2. You have $2,000 and you must pick one of the following choices:
Choice A: You have a 50% chance of losing $1,000, and a 50% chance of losing $0.
Choice B: You have a 100% chance of losing $500.
If these questions were to be answered logically, a subject might pick either “A” or “B” in both
situations. People who are inclined to choose “B” would be more risk adverse than those who
would choose “A”. However, the results of the study showed that a significant majority of people
chose “B” for question 1 and “A” for question 2.
The implication of this result is that individuals are willing to settle for a reasonable level of
gains (even if they also have a reasonable chance of earning more than those gains), but they
are more likely to engage in risk-seeking behaviors in situations in which they can limit their
losses. Put differently, losses tend to be weighted more heavily than an equivalent amount of
gains.
This line of thinking resulted in the asymmetric value function:

This chart represents the difference in utility (i.e. the amount of pain or joy) that is achieved as a
result of a certain amount of gain or loss. This value function is not necessarily accurate for
every single person; rather, it represents a general trend. One critical takeaway from this
function is that a loss tends to create a greater feeling of pain as compared to the joy created by
an equivalent gain. In the case of the chart, the absolute joy felt in finding $50 is significantly
less than the absolute pain caused by losing $50.
As a result of this tendency, during a series of multiple gain/loss events, each event is valued
individually and then combined in order to create a cumulative feeling. Thus, if you were to find
$50 and then lose $50, you’d probably end up feeling more frustrated than you would if you
hadn’t found or lost anything. This is because the amount of joy gained from finding the money
is outweighed by the amount of pain experienced by losing it, so the net effect is a “loss” of
utility.
Financial Relevance
Many illogical financial behaviors can be explained by prospect theory. For example, consider
people who refuse to work overtime because they don’t want to pay more taxes. These people
would benefit financially from the additional after-tax income, but prospect theory suggests
that the benefit they would achieve from earning extra money for additional work does not
outweigh the sense of loss they feel when they pay additional taxes.
The disposition effect is the tendency that investors have to hold on to losing stocks for too long
and to sell winning stocks too soon. Prospect theory is useful in explaining this phenomenon as
well. The logical course of action would be to do the opposite: to hold on to winning stocks in
order to further gains, while selling losing stocks in order to prevent additional losses.
The example of investors who sell winning stocks prematurely can be explained by Kahneman
and Tversky’s study, in which individuals settled for a lower guaranteed gain of $500 as
compared with a riskier option that could either yield a gain of $1,000 or $0. Both subjects in
the study and investors who hold winning stocks in the real world are overeager to cash in on
the gains that have already been guaranteed. They are unwilling to take a risk to earn larger
gains. This is an example of typical risk-averse behavior. (To read more, check out A Look At Exit
Strategies and The Importance Of A Profit/Loss Plan.)
On the other hand, though, investors also tend to hold on to losing stocks for too long. Investors
tend to be willing to assume a higher level of risk on the chance that they could avoid the
negative utility of a potential loss (just like the participants in the study). In reality, though,
many losing stocks never recover, and those investors end up incurring greater and greater
losses as a result. (To learn more, read The Art Of Selling A Losing Position.)
What is the Prospect Theory
Prospect theory assumes that losses and gains are valued differently, and thus individuals make
decisions based on perceived gains instead of perceived losses. Also known as "loss-aversion"
theory, the general concept is that if two choices are put before an individual, both equal, with
one presented in terms of potential gains and the other in terms of possible losses, the former
option will be chosen.
BREAKING DOWN Prospect Theory
For example, consider an investor is given a pitch for the same mutual fund by two
separate financial advisors. One advisor presents the fund to the investor, highlighting that it
has an average return of 12% over the past three years. The other advisor tells the investor that
the fund has had above-average returns in the past 10 years, but in recent years it has been
declining. Prospect theory assumes that though the investor was presented with the exact same
mutual fund, he is likely to buy the fund from the first advisor, who expressed the fund’s rate of
return as an overall gain instead of the advisor presenting the fund as having high returns and
losses.
Behind Prospect Theory
Prospect theory belongs to the behavioral economic subgroup, describing how individuals make
a choice between probabilistic alternatives where risk is involved and the probability of different
outcomes is unknown. This theory was formulated in 1979 and further developed in 1992 by
Amos Tversky and Daniel Kahneman, deeming it more psychologically accurate of how decisions
are made when compared to the expected utility theory. The underlying explanation for an
individual’s behavior, under prospect theory, is that because the choices are independent and
singular, the probability of a gain or a loss is reasonably assumed as being 50/50 instead of the
probability that is actually presented. Essentially, the probability of a gain is generally perceived
as greater.
Perceived Gains Over Perceived Losses
Tversky and Kahneman proposed that losses cause greater emotional impact on an individual
than does an equivalent amount of gain, so given choices presented two ways — with both
offering the same result — an individual will pick the option offering perceived gains.
For example, assume that the end result is receiving $25. One option is being given the straight
$25. The other option is gaining $50 and losing $25. The utility of the $25 is exactly the same in
both options. However, individuals are most likely to choose receiving the straight cash because
a single gain is generally observed as more favorable than initially having more cash and then
suffering a loss.

Equity premium puzzle - The average observed return to stocks is higher approximately by 8 per
cent than bond returns. Mehra, Prescott (1985) showed that under the assumptions of the
standard EU model, investors must be extremely risk averse to demand such high a premium,
which created a puzzle. Benartzi et al. (1995) suggested an answer based on reference
dependence, crucial aspect of CPT. They argued that in the short run, for example annually,
stock returns are negative much more frequently than bond returns. Loss averse investors will
then naturally demand large equity premium to compensate for the much higher chance of
losing money.

Expected utility theory is a theory of utility in which “betting preferences” of people with regard
to uncertain outcomes (gambles) are represented by a function of the payouts and the
probabilities of occurrence.
For example, there is a 50% chance of winning $1000 and 50% chance of winning $100, then
the expected utility would be:
Outcome 1= (0.5)*(1000) =$500
Outcome 2= (0.5)*(100) =$50
Total = $500 + $50 = $550
Choice between expected utility and prospect theory:
Gamble 1
Suppose I offer choice between two gambles-
Gamble A: Win $240 100%
Gamble A: Win $100 50%
Win $400 50%

Expected utility theory

Investor should choose the option which provides the highest expect utility. Here expected
utility for two options is-
A = (1)*(1000) =$1000
B = (0.5)*(100) + (0.5)*(400) =$250
According to the expected utility theory people would prefer Gamble B as it provides higher
expected utility. Whereas prospect theory observes that people would prefer Gamble A as
outcome is certain here.

Gamble 2
Suppose I offer choice between two gambles-
Expected Utility
Gamble A: Win $1000 100% =1000
Gamble A: Win $2500 50% = $1250
Win $0 50%
According to the expected utility theory people would prefer Gamble B as it provides higher
expected utility. Whereas prospect theory observes that most people would pick Gamble and
prefer a certain gain (the less risky option) over an uncertain gain of larger expected utility. In
case of gain investors are very risk averse.
Gamble 3
Suppose I offer choice between two gambles-
Expected Utility
Gamble A: Lose $1000 100% = (1000)
Gamble A: Lose $2500 50% = $(1250)
Lose $0 50%
According to the expected utility theory rational investors would prefer Gamble A as it provides
expected utility of losing the least. Whereas prospect theory observes that most people would
pick Gamble A. When confronted with losses, people often choose the riskier alternative and
they become risk seeker.
To sum up, People are risk averse when it comes to gains (they choose for the certain gain, even
if its expected utility is less). On the other hand, people are risk seeking when it comes to losses
( they choose for the uncertain loss, even if its expected utility is less).