Hi All, I am looking to clear up some confusion I have regarding this particular reading. A section in the book asks me to compare and contrast expected utility theory and prospect theories of investment decision making. Answer: Traditional finance is based in utility theory and an assumption of diminishing marginal return. This leads to two consequences. First, the risk-averse utility function is concave. Second, it leads to convex indifference curves due to diminishing marginal rate of substitution Decision Theory is focused on making the ideal decision when the decision maker is fully informed, mathematically able, and rational. The theory evolved over time.
-Initial analysis focused on selecting highest probability payoff.
-Later evolution separate expected value (Market price) and expected utility.
-Risk is defined as a random variable.
-Subjective analysis extends decision theory to situations where probabilities cannot be objectively measured but is subjective. I am going to break this up into a couple of sections because I am uncertain about a few things just from this question. 1) The card says “prospect theories”. What am I missing in that this is plural? I have been viewing prospect theory as a standalone theory.
- I don’t understand the answer to this question provided. Why is decision theory the answer? When I went about answering this I wrote: Traditional finance is based in utility theory. Ultility theory assumes no limits on cognitive ability to process information, efficient markets, and risk averse investors. Prospect theory is a descriptive theory that views decision making from a gain/loss perspective. Prospect theory relaxes the assumptions posed by utility theory by incorporating bounded rationality. Investors don’t have to be risk averse, markets may not be efficient, and investors satisfice. 2a) It seems I totally missed the mark on the question based on the answer provided, but I feel like I compared/contrasted Prospect theory and Utility theory here. What am I missing in how these fit together? 2b) How would you answer this without knowledge of the answer provided? 3) Bounded rationality and decision theory from the reading only seem to relax stringent assumptions. While prospect theory encompasses aspects of them to describe behavior. 3a) Any clarification here is welcomed. 3b) Decision theory is listed under the section that looks at behavioral theories, but is seems to have the same rules as traditional finance, only with the caveat that it evolved over time with different ways to handle expected value and utility, and that subjective analysis extends decision theory. Which leads me to believe that prospect theory is the end result of decision theories evolution (That extension it said). I haven’t been able to find this being explicitly connected together in the book. They all just seem to be separate pieces of text with bits and pieces from each other in the behavioral section. Any help on putting this all together would be greatly appreciated. Sorry for the wall of text, greatly appreciate any help.