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Prospect theory and the “forgotten” fourfold pattern of risk preferences
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Scholten, Marc and Read, Daniel (2014) Prospect theory and the “forgotten” fourfold pattern of risk preferences. Journal of Risk and Uncertainty, 48 (1). pp. 67-83. doi:10.1007/s11166-014-9183-2 ISSN 0895-5646.
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Official URL: http://dx.doi.org/10.1007/s11166-014-9183-2
Abstract
Markowitz (Journal of Political Economy 60:151–158, 1952) identified a fourfold pattern of risk preferences in outcome magnitude: When outcomes are large, people are risk averse in gains and risk seeking in losses, but risk preferences reverse when the outcomes are small, with people exhibiting risk seeking in gains and risk aversion in losses. This fourfold pattern was not addressed by either version of prospect theory (Kahneman and Tversky Econometrica 47:363–391, 1979; Tversky and Kahneman Journal of Risk and Uncertainty 5:297–323, 1992). We show how prospect theory can accommodate the pattern by combining an overweighting of low probabilities with a decreasingly elastic value function. We then examine the performance of prospect theory with two decreasingly elastic value functions: Prospect theory performs better, both quantitatively and qualitatively, with a normalized logarithmic value function than with a normalized exponential value function. We discuss several issues, and speculate about why Tversky and Kahneman did not address Markowitz’s fourfold pattern.
| Item Type: | Journal Article | ||||||
|---|---|---|---|---|---|---|---|
| Divisions: | Faculty of Social Sciences > Warwick Business School | ||||||
| Journal or Publication Title: | Journal of Risk and Uncertainty | ||||||
| Publisher: | Springer New York LLC | ||||||
| ISSN: | 0895-5646 | ||||||
| Official Date: | February 2014 | ||||||
| Dates: |
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| Volume: | 48 | ||||||
| Number: | 1 | ||||||
| Page Range: | pp. 67-83 | ||||||
| DOI: | 10.1007/s11166-014-9183-2 | ||||||
| Status: | Peer Reviewed | ||||||
| Publication Status: | Published | ||||||
| Access rights to Published version: | Restricted or Subscription Access |
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