Behavioral Finance Read 7 page 45-46 EOC #5

Hello,

EOC question #5 page 45-46 has answer C

Can anyone elaborate on why it’s not answer A - Prospect theory? it says in the answer key that “loss aversion in prospect theory is discussed from a different perspective”

not sure I understand that? we have 2 phases and then our subjective probabilities which leads to risk seeking behavior.

Prospect theory would indicate that individuals hold onto their losers too long. it is based on a reference point as well.

Hopefully, someone can shed some light on the “different perspective”.

Thank you,

Prospect theory different frame of Loss aversion seems to be from this point:

given the same variation in absolute value there is a bigger impact of losses than of gains (loss aversion). People are not risk-averse but rather are loss-averse. Pg 25.

So if the impact had been +15%, -15% (same on both directions) - Prospect theory might have worked.

Here it is a gain of 15%, vs. loss of 25% – from the reference point - which is the purchase price. So it is not prospect theory.

ok,

so how this translates is; equal change in variation up and down with a greater impact on “utiltity” (value) being experienced on the losses

is that correct?

what are you trying to say? it is not an equal change here … so where did the equal change appear on your statement from?

sorry, I was clarifying the defintition for Prospect Theory - Loss Aversion to made sure I knew it correctly.

that’s what i was stating

Here is what we thought:

Prospect theory is a framework that attempts to describe the decision making process made by a human being and non-rational investor. Utility theory is the opposite, the framework for the rational investor, which is based on an absolute frame rather than a subjective one. Utility theory tell us how to construct a portfolio in an objective manner, and comes up with mean-variance optimization. But in reality, many construct portfolios differently, for example they exhibit loss aversion. This loss aversion is reflected in the example by the different bounds for selling a gain and a loss. A loss is only sold at -25%, presumably to allow a smaller loss to re-gain in value because the investor does not want to accept a loss easily.

Behavoural portfolio theory describes this and other phenomena which gives rise to different portfolios than those prescribed by mean-variance derived from utility theory.

Prospect theory is not the right answer, because it is a decision making framework which is probably the basis of behavioural portfolio theory BUT ONLY for specific frame that for example give rise to loss aversion. It says how we decide, and BPT says how we construct portfolios based on the how.