Over the past decade, researchers have made substantial progress applying prospect theory in economic settings. Cumulative prospect theory describes decision making under risk and offers explanations to common decisions made in finance, insurance, consumption saving, and industry pricing, with the hope that some of these insights will eventually find a place in mainstream economic analysis.
Recent research on prospect theory has shown that it is applicable in finance, insurance, and other areas. Several papers, which measure skewness, have confirmed the prospect theory prediction that more positively skewed stocks will have lower average returns. Prospect theory can explain such financial phenomena as the equity risk premium puzzle, the lower long-term average returns of IPOs, and the lack of diversification in many household portfolios. It can also be used to explain why households prefer lottery-like payoffs, pay a high premium for insurance policies with low deductibles, and resist purchasing annuities. Finally, prospect theory can be helpful in understanding some aspects of how labor supply reacts to wage changes.
How Is This Research Useful to Practitioners?
Prospect theory has been applied mostly in finance and insurance. The author discusses the cross section of average returns and answers why some financial assets have higher average returns than others. For example, the capital asset pricing model (CAPM) is used to explain that higher risk (high beta) stocks should have higher average returns. Some argue that the CAPM does not have much empirical support. Prospect theory leads to a new theory that a security’s skewness in the distribution of its returns will be priced. By taking a significant position in a positively skewed stock, investors give themselves the chance of becoming wealthy if the stock turns out to be “the next Google.” According to prospect theory, investors overweight the tails of the distribution they are considering, which means they are willing to pay a very high price for the stock even when it means earning a low average return.
The equity premium puzzle questions why the average return on the U.S. stock market has exceeded the average return of Treasury bills by much more of a margin than predicted by traditional models. Prospect theory would suggest that because of loss aversion, the high dispersion of the market return is not attractive. Therefore, in order to compensate, the stock market needs to have a high average return and significantly higher return than safe assets.
Prospect theory can explain how people trade over time. Stocks exhibit a well-known momentum effect, but both individuals and mutual fund managers tend to do the opposite by selling their outperforming stocks and holding onto losses. This “disposition effect” also occurs with real estate and leads to significant mispricing.
How Did the Author Conduct This Research?
The author reviews the prospect theory model and its four elements: (1) reference dependence (people derive more utility from gains and losses measured relative to a reference than from absolute levels of wealth), (2) loss aversion (people are more sensitive to losses than gains of the same magnitude), (3) diminishing sensitivity (each additional dollar has a smaller utility impact at higher wealth levels), and (4) probability weighting (people overweight tail probabilities and underweight high tail probabilities). Some research has shown that prospect theory is less accurate in describing the actions of experienced traders, but the author believes that the best way to test prospect theory in the real world is to confront its predictions with data.
The author examines areas for application in which risk plays a central role and discusses efforts to integrate prospect theory into areas of economics. In addition to finance and insurance, he examines the endowment effect (the finding that people will pay more to retain something they own rather than obtain something owned by someone else), consumption-savings decisions, industry organization pricing strategies, and labor supply models. The author also mentions several other applications, such as the application of prospect theory in understanding the favorite-longshot bias in betting markets.
The author concludes by asking whether such observed behaviors as loss aversion or overpaying for IPOs should be thought of as mistakes. He suggests that one possible approach could be to explain prospect theory preferences to people and observe whether the new information causes them to change their behavior.
The author states that a current best-selling economic textbook makes no mention of prospect theory and asks whether more sense could be made of data by using models that are based on more realistic psychological assumptions. Most would agree that more research into the integration of prospect theory with economics would be beneficial. The author mentions many areas for future research, including public finance, health, economics, and macroeconomics. The application of prospect theory, whenever possible, is expected to result in better models than traditional ones based solely on expected utility.