Behavioral assignment 1
1st Assignment
Behavioral Finance
Course Code: 6314M0202Y University of Amsterdam Block II, Fall 2014
Your names: Your UvA student numbers:
Chavdar Tsenev 10840974 Luis Pena Alberto Cabral Alexander Ezedin
Q1
The reason for the majority of individuals choosing option A rather than B and option D rather than C has to do with misperception of probabilities. Even though according to Prospect theory people are risk averse in the gains region, they would fail to realize that a probability of 0.001 is very small and would rather be enticed by the small, but existing probability to win a huge sum - $10 000. Even though according to Prospect theory the individuals‘utility function is concave in the gains region, implying that they are risk averse, its shape changes to convex for very small probabilities.
Usually people treat the outcomes based on a reference point, usually their current wealth, from which they evaluate gains and losses. For that reason a certain gain of $10 is not perceived as bringing any significant utility to let’s say average middle-class individual, while the possibility, even though small, of winning $10 000 would actually bring a quite significant change to his wealth. The opposite goes for the perceived utilities and the utility function, when in the loss region. Even a small probability of losing a significant amount ($10 000), which will severely affect the wealth of the individuals is misperceived as relatively high and undesirable as opposed to the certain, but small loss of $10, which will not affect the wealth of the person around his reference point.
Some real life analogues of the conducted experiment might be buying a lottery ticket, where the individual even gets a small, but negative payoff, on average, or establishing a start-up business, where an entrepreneur invests capital with the hope of receiving higher return in time, instead of investing the money in a bond or
Behavioral Finance
Course Code: 6314M0202Y University of Amsterdam Block II, Fall 2014
Your names: Your UvA student numbers:
Chavdar Tsenev 10840974 Luis Pena Alberto Cabral Alexander Ezedin
Q1
The reason for the majority of individuals choosing option A rather than B and option D rather than C has to do with misperception of probabilities. Even though according to Prospect theory people are risk averse in the gains region, they would fail to realize that a probability of 0.001 is very small and would rather be enticed by the small, but existing probability to win a huge sum - $10 000. Even though according to Prospect theory the individuals‘utility function is concave in the gains region, implying that they are risk averse, its shape changes to convex for very small probabilities.
Usually people treat the outcomes based on a reference point, usually their current wealth, from which they evaluate gains and losses. For that reason a certain gain of $10 is not perceived as bringing any significant utility to let’s say average middle-class individual, while the possibility, even though small, of winning $10 000 would actually bring a quite significant change to his wealth. The opposite goes for the perceived utilities and the utility function, when in the loss region. Even a small probability of losing a significant amount ($10 000), which will severely affect the wealth of the individuals is misperceived as relatively high and undesirable as opposed to the certain, but small loss of $10, which will not affect the wealth of the person around his reference point.
Some real life analogues of the conducted experiment might be buying a lottery ticket, where the individual even gets a small, but negative payoff, on average, or establishing a start-up business, where an entrepreneur invests capital with the hope of receiving higher return in time, instead of investing the money in a bond or
References: Bagella, M., Becchetti, M., Ciciretti, R., 2003. The Earning Forecast Bias: a Comparative Analysis on US and EUROZONE Stock Markets Galasso, A., Simcoe, T., 2011. CEO overconfidence and innovation