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.
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.
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 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.
Based on an interview with Mohammed Abdellaoui and his article “Loss Aversion Under Prospect Theory: A Parameter-Free Measurement”1 (Management Science , October 2007).
1. Abdellaoui,M. ; Bleichrodt, H. ; Paraschiv C., “Loss Aversion Under Prospect Theory: A Parameter-Free Measurement”, Management Science , Vol. 53, n° 10, octobre 2007.
2. von Neumann J. et O. Morgenstern (1944), Theory of Games and Economic Behavior , Princeton University Press.
3. Kahneman, D., Knetsch, J. L. et Thaler, R. H. (1990), “Experimental tests of the endowment effect and the Coase theorem”, Journal of Political Economy , 98, 1325-1348.
4. Benartzi, S., et Thaler, R. H. (1995), “Myopic Loss Aversion and the Equity Premium Puzzle”, Quarterly Journal of Economics , 110, 73-92.
5. Mehra R., Prescott E. (1985), “The Equity Risk Premium: A Puzzle”, Journal of Monetary Economics , 15, 2, 145-161.
6. Abdellaoui,M. ; Bleichrodt, H. ; Paraschiv C., “Loss Aversion Under Prospect Theory: A Parameter-Free Measurement”, Management Science , Vol. 53, n° 10, octobre 2007.
In Loss Aversion Under Prospect Theory: A Parameter-Free Measurement, Mohammed Abdellaoui, Han Bleichrodt, and Corina Paraschiv propose the first non parametric 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.