Advances in prospect theory: Cumulative representation of uncertainty

Abstract

We develop a new version of prospect theory that employs cumulative rather than separable decision weights and extends the theory in several respects. This version, called cumulative prospect theory, applies to uncertain as well as to risky prospects with any number of outcomes, and it allows different weighting functions for gains and for losses. Two principles, diminishing sensitivity and loss aversion, are invoked to explain the characteristic curvature of the value function and the weighting functions. A review of the experimental evidence and the results of a new experiment confirm a distinctive fourfold pattern of risk attitudes: risk aversion for gains and risk seeking for losses of high probability; risk seeking for gains and risk aversion for losses of low probability.

Prospect theory reflects selective allocation of attention.

“…Arguably the most influential descriptive model in the expectation tradition is cumulative prospect theory (CPT, Kahneman & Tversky, 1979;Tversky & Kahneman, 1992).…”

The demand for health insurance and behavioural economics

“…A first potential aspect that may provide a welfare gain to insured when taking out SHI is loss aversion, which is a key insight from the 'cumulative prospect theory' developed by Tversky and Kahneman [18]. Loss aversion regards the phenomenon that 'losses loom larger than gains' and that 'the aggravation that one experiences in losing a sum of money appears to be greater than the pleasure associated with gaining the same amount' [11].…”

Tax Loss Offset Restrictions and Biased Perception of Risky Investments

“…Studies based on real data show that such rationality can be rarely observed; instead, decision-making in a wide range of situations systematically deviates from fundamental rationality postulate (Allais 1953, Ellsberg 1961, Kahneman and Tversky 1979, Tversky and Kahneman 1992.…”

“…4 The application of prospect theory allows us to depict investor behavior and risk-taking more accurately than rationality-based expected utility theory by accounting for behavioral aspects Tversky 1979, Tversky andKahneman 1992). Based on this theory, loss offset restrictions interact with the psychological imbalance of investors assigning more weight to a loss than to a correspondingly large gain.…”