Prospect Theory: Much Ado About Nothing?

Moshe Levy () and Haim Levy

Chapter 7 in Handbook of the Fundamentals of Financial Decision Making:In 2 Parts, 2013, pp 129-144 from World Scientific Publishing Co. Pte. Ltd.

Abstract: Prospect theory is a paradigm challenging the expected utility paradigm. One of the fundamental components of prospect theory is the S-shaped value function. The value function is mainly justified by experimental investigation of the certainty equivalents of prospects confined either to the negative or to the positive domain, but not of mixed prospects, which characterize most actual investments. We conduct an experimental study with mixed prospects, using, for the first time, recently developed investment criteria called Prospect Stochastic Dominance (PSD) and Markowitz Stochastic Dominance (MSD). We reject the S-shaped value function, showing that at least 62%–76% of the subjects cannot be characterized by such preferences. We find support for the Markowitz utility function, which is a reversed S-shaped Function—exactly the opposite of the prospect theory value function. It is possible that the previous results supporting the S-shaped value function are distorted because the prospects had only positive or only negative outcomes, presenting hypothetical situations which individuals do not usually face, and which are certainly not common in financial markets.

Keywords: Financial Decision Making; Asset Pricing; Prospect Theory; Utility Theory; Risk Aversion; Static Portfolio Theory; Stochastic Dominance; Dynamic Modeling; Dynamic Portfolio Theory; Tactical Asset Allocation; Kelly Strategy; Capital Growth (search for similar items in EconPapers)
Date: 2013
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Journal Article: Prospect Theory: Much Ado About Nothing? (2002)
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