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Human behavior is difficult to determine accurately, but can be expected, and this
applies to human behavior in financial matters or the so-called behavioral finance,
there are many theories of control and describes the investment decision through
human behavior. Will compare in this paper between the two theories, expected utility
.theory and prospect theory
.
:PROSPECT THEORY DEFINITION
Using the term "prospect" to refer to what we have so far called lotteries or gambles,
(i.e. a set of outcomes with a probability distribution over them), Kahnemann and
Tversky also state that where winning is possible but not probable, i.e. when
probabilities are low, most people choose the prospect that offers the larger gain. This
is illustrated by the second decision stage in the Allais Paradox.
Kahnemann and Tversky also found strong evidence of what they referred to as the
:reflection effect. To illustrate
Imagine an Allais Paradox-type problem, framed in the following way. You must
:choose between one of the two gambles, or prospects
Kahnemann and Tversky found that 20% of people chose D, while 92% chose B. A
similar pattern held for varying positive and negative prizes, and probabilities. This
led them to conclude that when decision problems involve not just possible gains, but
also possible losses, people's preferences over negative prospects are more often than
not a mirror image of their preferences over positive prospects. Simply put - while
they are risk-averse over prospects involving gains, people become risk-loving over
.prospects involving losses
The expected utility of an entity is derived from the expected utility hypothesis. This
hypothesis states that under uncertainty, the weighted average of all possible levels of
utility will best represent the utility at any given point in time.
THE DIFFERNCES BETWEEN EXPECTED UTILITY THEORY AND
:PROSPECT THEORY
:Summary of the key assumptions of expected utility theory
1- It is regarded to be rational to be an expected utility maximizer, as this
theory is based on compelling axioms about how people should behave.
Expected utility theory posits that decision makers choose the prospect that
maximizes their expected (or average) utility.
2- Under expected utility, risk preferences are captured by the shape of
the utility function. Decision makers are risk-averse if U(x) is concave, and
risk-seeking if U(x) is convex.
3- based on the tenet that decisions makers are risk-averse.
4- decision makers are rational.
5- Expected utility theory assumes that preferences between prospects do
not depend on the manner in which they are described, ( invariance
assumption).
6- Expected utility theory assumes that choices only reflect final
outcomes. For example, if one were the beneficiary of a $100 check, but also
received a $100 speeding ticket, these two events would offset one another in
monetary terms.
7- Expected utility theory assumes this principle—adding a common
consequence to two prospects should not change which alternative the
decision maker prefers. This principle is known as the independence axiom
CONCLUSION:
I see that both theories are a particular direction and have evidence of validity, but in
my opinion, the prospect theory has more evidence on the validity, because it
intervene in the psychological and social details that distinguishes people from each
other so there is no rationality at all human beings at all times when choosing
investment decision, Some seeks the expected utility and some seek the expected
value and the people in general be risk aversion at times and risk-loving At other
times and this is contrary to the expected utility theory, which calls for permanent
rational investor and risk aversion permanently.