Traditional finance assumes that investors behave rationally and evaluate the risk and potential return of investment strategies in terms of their expected utility or satisfaction. There are different ways of calibrating utility, but they all have the characteristic that they represent assumptions about how investors should be expected to express preferences. They have the additional characteristic that they can be modeled mathematically, which is convenient for modelers. Much less convenient is the widespread evidence that these rational utility models do not reflect how people view the prospect of financial gains or losses.
This has been reflected in prospect theory, which is built upon a wide range of experiments showing that people will take quite large risks to have some chance of avoiding otherwise certain losses, but that they are quick to bank any winnings. Investment banks tap into this investor preference through sales of highly pro? table principal-protected structured products, which provide downside protection with the prospect of some combination of leveraged positive returns. In other words, they offer a seductive combination of “little fear and much hope”. This relationship between the disutility or dissatisfaction that comes from losses and the utility or satisfaction that comes from gains is captured in the so-called coefficient of loss aversion, which across a wide range of experiments has come out at a value of around two. This measures how much more highly investors weigh losses than they weigh gains.
Tags: finance