Investigation of a Behavioural Model for Financial Decision Making

Abstract

Many economic models assume that individuals make decisions by maximizing
their expected utility. Expected utility theory was developed to explain
the way people behave when faced with choices under risk and uncertainty.
However, the explanatory power of this theory has come into question because
of systematic violations that have been observed in practice. This paper summarizes these violations and analyses a new theoretical framework that was
introduced to overcome these violations called prospect theory. This theory
was first proposed by Kahneman and Tversky in 1979, but the theory was later
modified to become cumulative prospect theory. The purpose of this paper is to
examine this new theory and to apply its framework to the lottery market. The
parameters of the functional form of cumulative prospect theory are estimated.
A value function with rapidly diminishing sensitivity, and a decision weighting
function that was essentially a step function is found. The implications of these results are examined, and these results are compared to estimates given in the literature.