Behavioral

FIN3399—
Special Topics in
Finance
Finance

Behavioral Finance

Winter Intersession
2022 Chapter 4 –
Utility & Prospect
Dr. Hind Lebdaoui
Theory
 Introduction
• Why are we inclined to sell the shares in our portfolio that are
performing well, and hold onto those that are performing
poorly?
• Why do we over-estimate the probability of plane crashes and
under-estimate the probability of car crashes?

Behavioral finance is a relatively new school of thought that

addresses and provides insight into questions like these. All of us
have innate psychological biases that can lead to predictable
“errors” in how we make important financial decisions. Behavioral
finance catalogues these errors and helps us to anticipate, and
hopefully avoid, these decision-making “traps.”

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 Certainty effect

Choose between:
$4000 with probability of 0.8 and $3000 with probability 1

• 80% of respondents chose certain outcome

$4000 with probability of 0.2 and $3000 with probability 0.25

▪ 35% of respondents chose latter option

People tend to OVERGEIGHT certain outcomes! This is called

certainty effect.
 Certainty effect

Choose between:
$4000 with probability of 0.8 and $3000 with probability 1

• 80% of respondents chose certain outcome

$4000 with probability of 0.2 and $3000 with probability 0.25

▪ 35% of respondents chose latter option

People tend to OVERGEIGHT certain outcomes! This is called

certainty effect.
 How Many Triangles?

How many triangles do you

see on this page?

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How Many Triangles?

Suppose we add a new shape: an

incomplete circle, as shown below.
Does it change the number of
triangles that you see?

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How Many Triangles?

Now let’s add a second

incomplete circle. Is anything
changing in your perception of
the number of triangles?

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How Many Triangles?

Now we have three incomplete

circles. We haven’t changed
the number of black triangles,
but has the addition of the
new shapes altered your
perception of the total number
of triangles on the page?

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 Utility of Money

Utility

U(10)

U(5)

“Utility” = happiness

U(0)
0 5 10 Wealth

Implications of the graph:

• More money is undoubtedly better than less: U(10) > U(5), BUT
• The incremental (marginal) value of an additional dollar gets smaller as our
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wealth increases: U(5) – U(0) > U(10) – U(5)
 The Utility of a Gamble: Risk Aversion

• What is the most you would pay to play the following game?

Toss a fair coin.

If it lands heads, you get $15
If it lands tails, you get $5

• The fair (or “expected”) value of the game is ½ x 15 + ½ x 5 = $10

•The fair (or “expected”) value of the game
• Would you pay $10 to play? If not, how much would you pay?
?
• What is your “utility” for the game?

U(G) = ½ U(15) + ½ U(5) where U(G) = the “utility” of the Game

•Would you pay $10 to play? If not, how
• much
How much would
will you payyou
to play pay? What is your
the game?

“utility” for the game?

You will pay $G, where: *To calculate expected value, multiply each possible outcome
with the probability of that outcome, and add all of these
U(G) = ½ U(15) + ½ U(5) probability-weighted outcomes together

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 The Utility of a Gamble: Risk Aversion

• What is the most you would pay to play the following game?

Toss a fair coin.

If it lands heads, you get $15
If it lands tails, you get $5

• The fair (or “expected”) value of the game is ½ x 15 + ½ x 5 = $10

• Would you pay $10 to play? If not, how much would you pay?

• What is your “utility” for the game?

U(G) = ½ U(15) + ½ U(5) where U(G) = the “utility” of the Game

• How much will you pay to play the game?

You will pay $G, where: *To calculate expected value, multiply each possible outcome
with the probability of that outcome, and add all of these
U(G) = ½ U(15) + ½ U(5) probability-weighted outcomes together

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 Risk Aversion
U[X] = X0.7
Utility
U(15)
These two
distances are U(10)
the same U(G)

U(5) Why are U(G)

and U(10)
different?
Risk aversion

5 G 10 15 Wealth

U(G) = ½ U(5) + ½ U(15) < U( ½ x 5 + ½ x 15) = U(10)

The probability-weighted sum …Is less …the utility of the expected

of the utilities for each than… value of the outcomes 6
outcome…
Take one minute to make a decision

Utilitity theory
• 50% go for Selling A
• 50% go for Selling B

Prospect theory
Even though the same money is
received
• Majority sells A
Feels better to sell a stock after you
gained 5K (then to sell one that lost
5K)
Feels better to sell a GAIN

© 2019 McGraw-Hill Education. 9-14

Take one minute to make a decision

Utilitity theory
• 50% go for Selling A
• 50% go for Selling B

Prospect theory
Even though the same money is
received
• Majority sells A
Feels better to sell a stock after you
gained 5K (then to sell one that lost
5K)
Feels better to sell a GAIN

© 2019 McGraw-Hill Education. 9-15

Prospect Theory

• Challenges conventional view of the

relationship between wealth and utility
• Utility is a function of change in wealth
• Investor utility depends on gains/losses
from starting position, rather than levels
of wealth
• Investors might be willing to take more
risks after losing
© 2019 McGraw-Hill Education. 9-16
© 2019 McGraw-Hill Education. 9-17
 Expected-Utility Theory
and Prospect Theory

Think of Margaret and Ann

Margaret’s wealth decreased from $4 million to $3 million

yesterday,
while Ann’s wealth increased from $1 million to $1.5 million

Who experiences greater happiness today?

And who reports higher life-evaluation?
 Expected-Utility Theory
and Prospect Theory

Two concepts of happiness:

“experienced happiness”
“life-evaluation”

Experienced happiness is also called emotional

well-being and hedonic well-being
 Expected-Utility Theory
and Prospect Theory

Experienced happiness is assessed by answers to

questions about yesterday’s experiences, such as
yesterday’s enjoyment, affection, sadness, or anger
Life-evaluation is assessed by Self-Anchoring Scale,
where people place themselves on a ladder whose
rungs go from the bottom “worst possible life” to the
top “best possible life”
Experienced happiness is “fleeting happiness”
Life-evaluation is “sustained happiness”
 Expected-Utility Theory
and Prospect Theory

The experienced-happiness of Ann is likely greater than

Margaret’s because Ann gained yesterday while Margaret lost

Ann experiences happiness and pride ☺

Margaret experiences sadness and regret 
But the life evaluation of Margaret is likely greater than Ann’s
because Margaret’s wealth is $3 million, exceeding Ann’s $1.5
million
 Expected-Utility Theory and Prospect Theory

Utility in prospect theory is gain-loss-utility --

experienced-happiness or fleeting happiness
derived from gains and losses of wealth
relative to a reference point

Levels of wealth yesterday, such as

Margaret’s $4 million and Ann’s $1 million, are
likely reference points
Gains and losses and Gain-Loss Utility in prospect theory

Prospect theory
Ann’s experienced
happiness today exceeds
Margaret’s:
• Ann gained $500,000
yesterday, relative to her
$1 million reference
point, a gain of 72 units
of gain-loss-utility
• whereas Margaret lost $1
million yesterday relative
to her $4 million
reference point, a loss of
188 units
 Expected-Utility Theory and Prospect Theory

Expected-utility theory predicts that people are not

confused by the frame of wealth

Prospect theory predicts that people are regularly confused

A frame that comes easily to the minds of Elizabeth and Ann

is prospect theory’s frame of gains and losses relative to
yesterday’s wealth as the reference point -- Ann gained
whereas Margaret lost

How can a friend of Margaret change her frame to cheer her

up?
 Expected-Utility Theory and Prospect Theory

Both expected-utility theory and prospect theory

offer predictions about choices
• Expected- utility theory— Reflects a preference
for high wealth over low wealth
• Prospect theory – people’s choices reflect a
preference for high gains over low gains or
losses.

Both theories also predict that choices reflect risk-

aversion, but definitions of risk by the two
theories differ
 Expected-Utility Theory and Prospect Theory

Variance-aversion and loss-aversion

Expected-utility theory predicts that all choices

reflect risk-aversion (Never risk-seeking) – where risk is
measured by the variance of returns
Prospect theory also predicts that all choices reflect
risk-aversion :can be
• variance-aversion,
• loss-aversion, or
• shortfall-aversion
 Expected-Utility Theory and Prospect Theory

Choices when all outcomes are in the domain-of-gains

Choose between:

A.a sure $10,000

B.a 50-50 gamble for $20,000 or $0
 Choices by expected-utility theory when gamble outcomes cannot
reduce total wealth
Suppose that current wealth is $20,000, yielding 220 units of A- The sure $10,000
wealth-utility brings total wealth to
$30,000, yielding 258
units of wealth-utility
B- The gamble is 50-50
chance to leave total
wealth at its current
$20,000, yielding 220
units of wealth-utility, or
bring it to $40,000,
yielding 270 units
220B < 245A units of
wealth-utility.
Therefore, expected-
utility theory predicts
that people would
choose the sure $10,000
245= (220+270)/2
Choices by prospect theory when outcomes are all in the domain of gains

The choice of the sure $10,000 is also

consistent with variance-aversion in
prospect theory for people whose
reference point is $0.

Both the sure amount and the possible

outcomes of the gamble are in the
domain-of-gains= neither can result in
a loss relative to the $0 reference point.
The sure $10,000 gain ->110 units of
gain-loss-utility.

A $20,000 gain in the 50-50 gamble

yields 137 units and a $0 gain yields 0
units: Mean units of gain-loss-utility is
68.5 units, a number lower than the
110 units yielded by the sure $10,000.

Therefore, prospect theory predicts

that people would choose the sure
$10,000.
 Expected-Utility Theory and Prospect Theory

Choices when some outcomes are in the domain-of-losses

Loss aversion

Choose between:
A.a sure $0
B. a 50-50 gamble for a $20,000
gain or a $5,000 loss
 Choices by expected-utility theory when some outcomes can reduce total wealth

Current wealth is $20,000, yielding 220

units of wealth-utility.
The sure $0 leaves total wealth
unchanged at $20,000, yielding the same
220 units.
The gamble offers a 50-50 chance to
reduce total wealth to $15,000, yielding
185 units of wealth utility, or increase it
to $40,000, yielding 270 units.
The mean of 185 units and 270 units of
wealth-utility associated with the gamble
is 227.5 units, a number higher than the
220 units of utility associated with the
sure amount. Therefore, expected-utility
theory predicts that people would
choose the gamble.

A. a sure $0
B. a 50-50 gamble for a $20,000 gain or a $5,000 loss
Choices by prospect theory when some outcomes are in the domain-of-losses

The sure $0 yields zero uts of gain-loss-utility.

A $20,000 gain in the 50-50 gamble yields 137
uts of gain-loss-utility
$5,000 loss yields a loss of 150 units of gain-
loss-utility.
The mean of the gamble’s units of gain-loss-
utility is a negative 6.5 units of gain-loss
utility, a number lower than the zero units
yielded by the sure amount.
Therefore, prospect theory predicts that
people would reject the gamble and choose
the sure $0.

Does Loss aversion

level matter?

A. a sure $0
B. a 50-50 gamble for a $20,000 gain or a $5,000 loss
 Choices of people who vary in loss-aversion
• The medium loss-averse person
rejects the gamble ( mean gain-
loss utility of 137 units and a
negative 150 units is ).
• The high loss-averse person
rejects the gamble even more
emphatically because its mean
gain-loss utility of 137 units and
a negative 195 units is a negative
29 units.
• The low loss-averse person
accepts the gamble however,
because its mean gain-loss utility
of 137 units and a negative 120
units is 8.5 units, higher than the
zero gain-loss utility associated
with the sure $0.
 Expected-Utility Theory and Prospect Theory

Questions

Suppose that you are given an opportunity to replace your current investment
portfolio with a new one

The new portfolio has a 50-50 chance for a 50% gain in your lifetime standard
of living

Yet the new portfolio also has a 50-50 chance for an X % loss in your lifetime
standard of living

What is the maximum X% loss in lifetime standard of living you are willing to
accept for a 50-50 chance to gain 50% in lifetime standard of living?
Loss-aversion of men and women in China, U.K., U.S., and Vietnam

4.93

4.33

3.81
3.66
3.27
3.11
2.77 2.87

Men Women Men Women Men Women Men Women

China United Kingdom United States Vietnam
 Expected-Utility Theory and Prospect Theory

Shortfall-aversion

Shortfall-aversion differs from loss-aversion, although the

two are often confused

The reference point in loss-aversion is our current position

In contrast, the reference point in shortfall-aversion is an

aspiration level higher than our current position
 Expected-Utility Theory and Prospect Theory

Shortfall-aversion

• Shortfall aversion reflects the higher utility loss of a

spending cut from a reference point than the utility
gain from a similar spending increase, in the spirit
of Prospect Theory's loss aversion.

• This paper posits a model of utility of spending

scaled by a function of past peak spending, called
target spending.
 Expected-Utility Theory and Prospect Theory

Shortfall-aversion

Choose between:

A. a sure $5,000 loss

B. a 50-50 gamble for a $15,000
loss or a $0 loss
Shortfall-aversion in prospect theory
The choice of the gamble is
consistent with shortfall-aversion
of people whose choices conform
to prospect theory.
The mean gain-loss utility of the
gamble is a negative 102.5 units,
the mean of a negative 205 units
and zero units, still better than the
loss of 150 units of gain-loss utility
of the sure $5,000 loss.

A. a sure $5,000 loss

B. a 50-50 gamble for a $15,000 loss or a $0
loss
 Expected-Utility Theory and Prospect Theory

Shortfall-Aversion example

Marathon runners’ shortfall aversion is evident in the

bunching of finishing times at round numbers, such
as 4 hours, that runners set as their finishing- time
aspirations. A study of more than 9 million marathon
finishing times uncovered such bunching, driven by
increased effort near the finish line as runners strain
to avoid shortfalls from their finishing- time
aspirations.
 Subjective vs Objective Probabilities— Probability weights

Theory predicts that people use objective probabilities

of possible outcomes as they consider choices,
Prospect theory predicts that people use subjective
probabilities that can depart from objective
probabilities.
“Probability weights” are ratios of subjective
probabilities to objective probabilities
Objective probability indicates a 1-in-1,000,000 chance
to win the lottery, but a 100,000 probability weight
overweighs this objective probability to a subjective
probability to a 1-in-10 chance
 Probability weight

Think of a $20 lottery ticket that offers an objective 0.001% probability

to win a $1 million prize

The expected payoff of the ticket is $10, the product of the 0.001%
objective probability and the $1 million prize

Does expected-utility theory predicts that we are willing to buy the

ticket?

Does prospect theory predicts that we are willing to buy the ticket?
(a) Emotional benefits of hope of winning a large amount, (b) Emotional costs of fear of losing a large amount, ©Emotional benefits of hope
of avoiding a sure loss of a large amount, (d) Emotional costs of anticipated regret of foregoing a sure gain of a large amount

Compute the probability weight in each case

Case
Emotional benefits of hope 1 a large amount
of winning Emotional costs of fear of losing a Case 2
large amount

Question: Pay $20 for a ticket to a $1 million lottery? Question: Pay $2,000 to insure a $1 million house?
Objective probability of winning = 0.001% Objective probability of fire = 0.1%
Subjective probability of winning = 10% Subjective probability of fire = 1%
Probability weight = 10,000 Probability weight = 10
Choice: We buy the lottery ticket Choice: We buy insurance

Emotional costs of anticipated regret of foregoing Emotional benefits of hope of avoiding

Case 3 Case4
a sure gain of a large amount a sure loss of a large amount

Question: Accept $700,000 as settlement or proceed to trial Question: Pay $700,000 as settlement or proceed to trial

with a 95% probability of receiving $1 million? with a 95% probability of paying $1 million?

Objective probability of receiving zero in trial = 5% Objective probability of paying zero in trial = 5%

Subjective probability of receiving zero in trial = 40% Subjective probability of paying zero in trial = 40%
Probability weight = 8 Probability weight = 8
Decision: We accept the settlement Decision: We proceed to trial
(a) Emotional benefits of hope of winning a large amount, (b) Emotional costs of fear of losing a large amount, ©Emotional benefits of hope
of avoiding a sure loss of a large amount, (d) Emotional costs of anticipated regret of foregoing a sure gain of a large amount

Compute the probability weight in each case

Emotional benefits of hope of winning a large amount Emotional costs of fear of losing a large amount

Question: Pay $20 for a ticket to a $1 million lottery? Question: Pay $2,000 to insure a $1 million house?
Objective probability of winning = 0.001% Objective probability of fire = 0.1%
Subjective probability of winning = 10% Subjective probability of fire = 1%
Probability weight = 10,000 Probability weight = 10
Choice: We buy the lottery ticket Choice: We buy insurance

Emotional costs of anticipated regret of foregoing Emotional benefits of hope of avoiding

a sure gain of a large amount a sure loss of a large amount

Question: Accept $700,000 as settlement or proceed to trial Question: Pay $700,000 as settlement or proceed to trial

with a 95% probability of receiving $1 million? with a 95% probability of paying $1 million?

Objective probability of receiving zero in trial = 5% Objective probability of paying zero in trial = 5%

Subjective probability of receiving zero in trial = 40% Subjective probability of paying zero in trial = 40%
Probability weight = 8 Probability weight = 8
Decision: We accept the settlement Decision: We proceed to trial
Emotional benefits of hope of winning a large amount

Question: Pay $20 for a ticket to a $1 million lottery?

Objective probability of winning = 0.001%

Subjective probability of winning = 10%
Probability weight = 10,000

Choice: We buy the lottery ticket

 Emotional costs of fear of losing a large amount

Question: Pay $2,000 to insure a $1 million house?

Objective probability of fire = 0.1%

Subjective probability of fire = 1%
Probability weight weight = 10

Choice: We buy insurance

Emotional costs of anticipated regret of foregoing a sure gain
of a large amount

Question: Accept $700,000 as settlement or proceed to trial

with a 95% probability of receiving $1 million?

Objective probability of receiving zero in trial = 5%

Subjective probability of receiving zero in trial = 40%
Probability weight = 8

Decision: We accept the settlement

Emotional benefits of hope of avoiding a sure loss of a large
amount

Question: Pay $700,000 as settlement or proceed to trial with a 95%

probability of paying $1 million?

Objective probability of paying zero in trial = 5%

Subjective probability of paying zero in trial = 40%
Probability weight = 8

Decision: We proceed to trial

Extra
Two Decisions with Gains and Losses

Here are two decisions, each of which has two alternatives. Please decide which
alternative you prefer among the two in Decision 1, and which you prefer in
Decision 2. Make a note of your selections before moving on.

Decision 1 Which do you prefer:

A or B?
Alternative A: A sure gain of $240

Alternative B: A 25% chance to gain $1,000, and a 75% chance to

gain nothing

Which do you prefer:

C or D? Decision 2

Alternative C: A sure loss of $750

Alternative D: A 75% chance to lose $1,000, and a 25% chance to

lose nothing

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 Example 1:
Two Decisions with Gains and Losses
Decision 1
A B
C -$510 -$750 $250

Decision 2 100% 75% 25%

D -$760 $240 -$1000 $0 $1000

75% 25% 56% 38% 6%

Each of the 4 rectangles above shows the range of outcomes and outcome probabilities from
the combination of the two decisions, based on the two possible alternatives in each case.

For example, if you picked A & C (the top left outcome), you will lose exactly $510

If you picked B & D (bottom right), you will: But these are not the
• lose $1,000 with 56% probability
interesting outcomes
• neither win nor lose with 38% probability
• win $1,000 with 6% probability
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 Example 1:
Two Decisions with Gains and Losses
Decision 1
A B
C -$510 -$750 $250

Decision 2 75% 25%

D -$760 $240 -$1000 $0 $1000

75% 25% 56% 38% 6%

Did you select A & D (bottom left)? If so, you are like about 50% of people who play this game. You will:
• Lose $760 with probability 75%
• Win $240 with probability 25%

Now compare A & D (bottom left) with B & C (top right). They look very similar, except that B & C is
better in both cases! For B & C, you have:
• The same 75% probability of losing money, but you lose a little less (only $750, instead of $760).
• The same 25% probability of making money, but you make a little more ($250 instead of just $240).

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 Example 1:
Two Decisions with Gains and Losses

A
Decision 1 B
C -$510 -$750 $250

Decision 2 75% 25%

D -$760 $240 -$1000 $0 $1000

75% 25% 56% 38% 6%

Economists would say that B & C dominates A & D, because with the former combination, you do a little
bit better in either probability scenario. So why do around 50% of respondents typically select the
dominated A & D outcome?
There are two principal reasons:
(1) We are not good at looking at outcomes over multiple games (in this case, Decision 1 followed by
Decision 2). We tend to treat each one as a stand-alone decision (we’ll see later that this provokes
“irrational” decisions about whether to buy product insurance)
(2) We are inclined to be risk–seeking in certain predictable scenarios. We will see that this has
significant implications across a whole host of financial decisions. 23