Download Loss Aversion and Decision-Making

Loss Aversion
and Decision-Making
Can decision-making under risk be improved without taking into account
the difference in people's sensitivity to gains and losses? Mohammed
Abdellaoui does not believe this is possible, and proposes a model for
measuring loss aversion under Prospect Theory.
CAREER
Prospect Theory, a theory that describes decisions
between alternatives that involve risk, was developed by Daniel Kahneman. He was awarded
the 2002 Nobel Prize in Economics for his work in
Prospect Theory, which revealed an important
element of behaviour under risk: the phenomenon
known as loss aversion. This refers to the tendency
for people strongly to prefer avoiding losses
than acquiring gains. Loss aversion explains many
empirical observations, especially in the financial
markets. Mohammed Abdellaoui is leading a research
programme that aims, among other things, to
measure this phenomenon, with the specific aim
of improving decision-making.
FUNDAMENTAL QUESTIONS RELATING
TO DECISION UNDER UNCERTAINTY
Mohammed Abdellaoui's work on decision under
uncertainty focuses on three key questions: how
can rational decisions be made under uncertainty
(normative considerations)? How do individuals and
organizations make choices in situations where they
have to decide between alternatives with uncertain
outcomes (descriptive considerations)? How can a
decision-maker who has to choose between alternatives with uncertain outcomes be helped to make
the right decision (prescriptive considerations)? The
recent appointment of a research team to study
Behavioral Decision Making in the GREGHEC research
laboratory aims to answer these questions through
research conducted by HEC. The business school
provides an ideal environment for this kind of research,
which is why questions relating to the improvement
of decision-making are given priority in the HEC
team's research programmes.
MEASURING PREFERENCES: A PREREQUISITE
FOR IMPROVING DECISION-MAKING
Decision Analysis, a discipline that uses a
standard model of rational choices in risk situations to improve decision-making2, was developed
by Howard Raiffa in 1968. The main idea behind
Decision Analysis is to reveal a decision maker's
preferences when faced with simple choices, and
use them as a basis for determining how they're
likely to react in more complex situations.
A decision maker's preferences are revealed through
the subjective values they attribute to the consequences of their decisions (utility functions) and
their beliefs about the likelihood of the uncertain
events they're dealing with (subjective probabilities). Several laboratory and field studies have
shown, however, that it's impossible to ignore
certain tendencies when measuring individual
preferences (in simple risk situations). Prospect
Theory allows us to measure preferences that take
these tendencies into account. Moreover, the
possibility of measuring loss aversion enables us
to take into account decision makers' trade-offs
between gains and losses more explicitly.
Mohammed Abdellaoui
holds a PhD
in economics,
mathematics, and
econometrics from
the University of AixMarseille III. He joined
the CNRS (French
National Scientific
Research Centre) in 1992
and became director
of research in 2001.
In 2007, he joined HEC
Paris as researcher in
the GREGHEC research
laboratory and
associate professor
of decision sciences.
A specialist in risk and
time perception, he has
published many articles
(in journals such
as Econometrica,
Management Science,
and the Journal of
Econometrics). He has
co-published works
on the recent progress
made in modelling
decision under
uncertainty, and is
editor-in-chief of the
international journal
Theory and Decision.
▼
Based on an interview with Mohammed Abdellaoui and his article “Loss Aversion Under Prospect Theory:
A Parameter-Free Measurement”1 (Management Science, October 2007).
June-July 2008
• research@hec VII
z
hec
EXAMPLES OF PHENOMENA EXPLAINED
BY LOSS AVERSION
Loss aversion was first proposed as an explanation for the endowment effect3—the fact that when
people buy and sell goods, they place a higher value
on objects they own than objects that they do not.
The general explanation for this is that when a
person gains possession of an object, it's integrated into their assets and serves as a reference point.
People are therefore more acutely aware of being
deprived of an object (loss) than gaining possession of it (gain). Loss aversion has also been used
to explain a phenomenon observed in the financial
markets, known as the equity premium puzzle4.
Equity premium refers to the difference between
return on stock and government bonds. The equity
RESEARCH METHODOLOGY
In Loss Aversion Under Prospect Theory: A Parameter-Free
Measurement, Mohammed Abdellaoui, Han Bleichrodt,
and Corina Paraschiv propose the first nonparametric method
for measuring loss aversion6. This method has enabled the
authors to compare and study the feasibility of different
definitions of loss aversion in the laboratory and also
(recently) for the benefit of finance professionals in the
United States. This research also opens up the possibility
of establishing ‘risk profiles’ for decision makers, and
especially for investors in financial markets. This will enable
banks to produce precise risk profiles of investors—after
conducting preliminary interviews with people wishing to
make investments with some element of risk—and offer
them products that are best suited to their preferences.
The development of such techniques, which is being
carried out at GREGHEC and in collaboration with other
researchers in France and abroad, uses some of the methods
outlined in the study above.
VIII
research@hec
•
June-July 2008
premium is approximately an annualized average
8%5. This value, based on expected utility hypothesis,
means that individuals must have implausibly high
risk aversion. The possibility of loss when holding
shares is compensated by the requirement for
compensation in terms of equity premium.
Mohammed Abdellaoui addresses the need for a
common definition of loss aversion that would make
it possible to take into account—in a reliable and
simple way—trade-offs between gains and losses
to improve decision-making.
1. Mohammed Abdellaoui, Han Bleichrodt, and Corina Paraschiv, “Loss Aversion Under Prospect Theory: A ParameterFree Measurement,” Management Science, Vol. 53, No. 10,
October 2007.
2. Jon von Neumann J. and Oskar Morgenstern (1944), Theory
of Games and Economic Behavior, Princeton University Press.
3. Daniel Kahneman, Jack L. Knetsch, and Richard H. Thaler
(1990), “Experimental Tests of the Endowment Effect and the
Coase Theorem,” Journal of Political Economy, 98, 1325-1348.
4. Shlomo Benartzi, and Richard H. Thaler (1995), “Myopic Loss
Aversion and the Equity Premium Puzzle,” Quarterly Journal
of Economics, 110, 73-92.
5. R. Mehra and E. Prescott (1985), “The Equity Risk Premium:
A Puzzle,” Journal of Monetary Economics, 15, 2, 145-161.
6. Mohammed Abdellaoui, Han Bleichrodt, and Corina Paraschiv, “Loss Aversion Under Prospect Theory: A ParameterFree Measurement,” Management Science, Vol. 53, No. 10,
October 2007.
■
▼
research