|
on Utility Models and Prospect Theory |
| By: | Benjamin Eden (Department of Economics, Vanderbilt University) |
| Abstract: | The standard power utility function is widely used to explain asset prices. It assumes that the coefficient of relative risk aversion is the inverse of the elasticity of substitution. Here I use the Kihlstrom and Mirman (1974) expected utility approach to relax this assumption. I use time consistent preferences that lead to time consistent plans. In our examples, the past does not matter much for current portfolio decisions. The risk aversion parameter can be inferred from experiments and introspections about bets in terms of permanent consumption (wealth). Evidence about the change in the attitude towards bets over the life cycle may also restrict the value of the risk aversion parameter. Monotonic transformations of the standard power utility function do not change the predictions about asset prices by much. Both the elasticity of substitution and risk aversion play a role in determining the equity premium. |
| Keywords: | Consumption smoothing, intertemporal elasticity of substitution, risk aversion, asset prices, equity premium <br><br> |
| JEL: | D11 D81 D91 G12 |
| Date: | 2008–01 |
| URL: | http://d.repec.org/n?u=RePEc:van:wpaper:0803&r=upt |
| By: | Astrid Matthey (Max-Planck-Institute of Economics) |
| Abstract: | The paper introduces the concept of adjustment utility, that is, reference-dependent utility from expectations. It offers an explanation for observed preferences that cannot be explained with existing models, and yields new predictions for individual decision making. The model gives a simple explanation for, e.g., why people are reluctant to change their plans even when these turn out to be unexpectedly costly; people's aversion towards positive but false information, which cannot be explained with previous models; and the increasing acceptance of risks when people get used to them. |
| Keywords: | utility, expectations, reference-dependent preferences, anticipation, prospect theory, experiments |
| JEL: | D11 D81 D84 C99 |
| Date: | 2008–01–15 |
| URL: | http://d.repec.org/n?u=RePEc:jrp:jrpwrp:2008-003&r=upt |
| By: | Hagströmer, Björn (Aston Business School); Anderson, Richard G. (Federal Reserve Bank of St. Louis); Binner, Jane (Aston Business School); Elger, Thomas (Department of Economics, Lund University); Nilsson, Birger (Department of Economics, Lund University) |
| Abstract: | In the Full-Scale Optimization approach the complete empirical financial return probability distribution is considered; and the utility maximizing solution is found through numerical optimization. Using a portfolio choice setting of three UK equity indices we identify several utility functions featuring loss aversion and prospect theory; under which Full-Scale Optimization is a substantially better approach than the mean-variance approach. As the equity indices have return distributions with small deviations from normality; the findings indicate much broader usefulness of Full-Scale Optimization than has earlier been shown. The results hold in and out of sample; and the performance improvements are given in terms of utility as well as certainty equivalents. |
| Keywords: | portfolio choice; utility maximization; full-scale optimization; S-shaped utility; bilinear utility |
| JEL: | G11 |
| Date: | 2007–10–24 |
| URL: | http://d.repec.org/n?u=RePEc:hhs:lunewp:2008_001&r=upt |
| By: | Enrico Diecidue; Ulrich Schmidt; Horst Zank |
| Abstract: | This paper provides preference foundations for parametric weighting functions under rankdependent utility. This is achieved by decomposing the independence axiom of expected utility into separate meaningful properties. These conditions allow us to characterize rank-dependent utility with power and exponential weighting functions. Moreover, by allowing probabilistic risk attitudes to vary within the probability interval, a preference foundation for rank-dependent utility with parametric inverse-S shaped weighting function is obtained. |
| Keywords: | Comonotonic independence, probability weighting function, preference foundation, rank-dependent utility |
| JEL: | D81 |
| Date: | 2008–01 |
| URL: | http://d.repec.org/n?u=RePEc:kie:kieliw:1395&r=upt |
| By: | Paun, Cristian; Musetescu, Radu; Brasoveanu, Iulian; Draghici, Alina |
| Abstract: | Risk aversion is reflected on a risk premium, which consists of an expected extra return that investors require to be compensated for the risk of holding stocks. We intend to evaluate the situation of Romania in terms of risk aversion. This study is very useful for understanding the differences between the individual investment behaviours in EU and to understand the further European market evolution taking into consideration this important variable – risk aversion. |
| Keywords: | risk aversion; individual investor; Romanian capital market |
| JEL: | G2 G11 |
| Date: | 2007–10–15 |
| URL: | http://d.repec.org/n?u=RePEc:pra:mprapa:6842&r=upt |
| By: | M. Menegatti |
| Abstract: | This work shows that the risk premium can be a mistaken measure of the reduction in utility caused by uncertainty since, when different level of wealth are considered, the relative size of the former is related to that of the latter only in some cases. The analysis indicates that this is because the size of the risk premium depends both on the size of the disutility of risk and on the size of the marginal utility of money. Some simple economic problems where this conclusion is relevant are also examined. |
| Keywords: | Risk premium, Uncertainty, Utility |
| JEL: | D11 D81 |
| Date: | 2007 |
| URL: | http://d.repec.org/n?u=RePEc:par:dipeco:2007-ep10&r=upt |
| By: | Astrid Matthey; Nadja Dwenger |
| Abstract: | The higher our aspirations, the higher the probability that we have to adjust them downwards when forming more realistic expectations later on. This paper shows that the costs induced by high aspirations are not trivial. We first develop a theoretical framework to identify the factors that determine the effect of aspirations on expected utility. Then we present evidence from a lab experiment on the factor found to be crucial: the adjustment of reference states to changes in expectations. The results suggest that the costs of high aspirations can be significant, since reference states do not adjust quickly. We use a novel, indirect approach that allows us to infer the determinants of the reference state from observed behavior, rather than to rely on cheap talk. |
| Keywords: | aspirations, reference state, expectations, individual utility, experiments |
| JEL: | D11 D84 C91 |
| Date: | 2008–01 |
| URL: | http://d.repec.org/n?u=RePEc:hum:wpaper:sfb649dp2008-011&r=upt |
| By: | Alexander Zimper; Alexander Ludwig (Mannheim Research Institute for the Economics of Aging (MEA)) |
| Abstract: | Psychological evidence suggests that people’s learning behavior is often prone to a “myside bias”or “irrational belief persistence”in contrast to learning behav- ior exclusively based on objective data. In the context of Bayesian learning such a bias may result in diverging posterior beliefs and attitude polarization even if agents receive identical information. Such patterns cannot be explained by the standard model of rational Bayesian learning that implies convergent beliefs. As our key contribution, we therefore develop formal models of Bayesian learning with psychological bias as alternatives to rational Bayesian learning. We derive condi- tions under which beliefs may diverge in the learning process and thus conform with the psychological evidence. Key to our approach is the assumption of am- biguous beliefs that are formalized as non-additive probability measures arising in Choquet expected utility theory. As a speci…c feature of our approach, our models of Bayesian learning with psychological bias reduce to rational Bayesian learning in the absence of ambiguity. |
| JEL: | C79 D83 |
| Date: | 2007–12–31 |
| URL: | http://d.repec.org/n?u=RePEc:mea:meawpa:07155&r=upt |
| By: | Gerlinde Fellner (Department of Economics, Vienna University of Economics & B.A.); Matthias Sutter (University of Innsbruck, Deparment of Public Finance, and University of Goeteborg) |
| Abstract: | We examine in an experiment the causes, consequences and possible cures of myopic loss aversion (MLA) for investment behaviour under risk. We find that both, investment horizons and feedback frequency contribute almost equally to the effects of MLA. Longer investment horizons and less frequent feedback lead to higher investments. However, when given the choice, subjects prefer on average shorter investment horizons and more frequent feedback. Exploiting the status quo bias by setting a long investment horizon or low feedback frequency as a default turns out to be a successful behavioural intervention that increases investment levels. |
| JEL: | C91 D80 G11 |
| Date: | 2008–01 |
| URL: | http://d.repec.org/n?u=RePEc:wiw:wiwwuw:wuwp116&r=upt |
| By: | Maarten van Rooij; Federica Teppa |
| Abstract: | The default option in individual decision making has proved to be a major attractor in a large number of situations, but we still have little information on the reasons why decision makers so often stick to the default choice. We have devised a new module for the Dutch DNB Household Survey to learn about default behavior and to discriminate between potential explanations. The main contributions of this paper are as follows. First, we identify potential explanations for default choices (including procrastination, inertia, illiteracy, obedience and regret aversion). Second, we provide empirical evidence on their relative importance in a large number of situations. Third, our survey data allow us to analyze the entire population distribution instead of selected groups (like workers, or students) and to control for a rich set of personal characteristics, as well as for labor market status, income, and wealth. Our findings confirm that the default choice plays a key role in individual decision making. Inaddition, we show that its relevance differs across domains: the default option attracts the majority of preferences in situations where the marginal disutility associated with postponing the decision is relatively low, or where the choice problem is increasingly complex. Moreover, we find that even though choice behavior is principally driven by different reasons across different situations overall procrastination and financial illiteracy provide the mostpowerful explanations for why people stick to the default. |
| Keywords: | default options; individual preferences; individual decision making; behavioral economics; procrastination; financial literacy |
| JEL: | D12 D80 |
| Date: | 2008–01 |
| URL: | http://d.repec.org/n?u=RePEc:dnb:dnbwpp:165&r=upt |