Most, if not all who have done financial modeling have made some use of prospect theory in order to assess and measure risk in financial instruments, although this use has yet to be widespread throughout the risk management community. The reason for this is very simple: prospect theory gives another view of risk that is different from the traditional one offered by classical economics, and one that is closer to what is exemplified in real economic data. Its theoretical foundations are less clear however, as compared to what is found in the now canonical approaches to risk based on Merton, Black, Scholes, etc. In prospect theory it is assumed that individuals make financial decisions relative to a reference point, and loss aversion plays a predominant role. In housing markets for example, some homeowners are reluctant to sell their properties if the prices fall below the market value. Empirical data shows that when house prices decline, houses sit for exceedingly long periods of time with their asking prices exceeding greatly the expected selling prices. These houses are usually withdrawn from the market without being sold. Classical economic theory would suggest that they would be sold with the asking price being very close to the market price, since the sellers are assumed to be rational and weigh expected gains in the same way as they expected losses. In prospect theory however, the value function for an individual is concave in gains but convex in losses, and is much more sensitive to losses that to gains of an equivalent size.
Prospect theory is thoroughly and beautifully discussed in this book and this is due to some degree by the presence of articles written by Daniel Kahneman and Amos Tversky, its originators. As outlined by these two researchers, prospect theory asserts that individuals tend to be sensitive to changes in values rather than absolute values and have diminishing marginal sensitivity to changes. This is reflected in the shape of their utility functions: qualitatively speaking they are steepest in regions where the marginal sensitivity to change is greatest and then they flatten out in directions where the changes in wealth increase. As a consequence, individuals prefer a small gain that is certain to a larger gain that is uncertain. Conversely, they prefer the possibility of a larger gain than the certainty of a small loss.
To motivate the content of the book, Kahneman writes an excellent preface, giving an overview of what to expect in the book and thus allowing readers to assign their own weights to which particular articles they find of interest. Some readers may want to read the entire book, but it seems likely that only selected articles will be chosen for careful study, based of course on the background of the reader. However, the first article in the book, which was published by Kahneman and Tversky in 1983, should probably be read by everyone interested in prospect theory and its foundations. The second article is a more quantitative formulation of what was said in the first, and contains an in-depth critique of expected utility theory. The content of this article should be helpful to those readers who work in a risk management environment and need to construct realistic models of choice under risk.
If the development of these models is guided by prospect theory, the analyst will arrive at a final product that could with fairness be classified as "microeconomic." The challenge in using prospect theory is to conglomerate the individual choices so that a risk manager can speak intelligently of the risk of a portfolio that is based on these individual choices. Some insight that could guide this development can be found in Part Five of the book, which covers applications of prospect theory. One particular article that stands out in this regard is the one by S. Benartzi and R. H. Thaler on the equity premium puzzle. This article attempts to understand, in the context of prospect theory, why fixed income securities have underperformed relative to stocks for the last nine decades, from about a 7% annual real return on stocks to a 1% return on treasury bills. The author's simulations indicate that the loss aversion aspect of prospect theory gives a better explanation to the equity premium puzzle than the traditional approaches based on expected maximum utility.
Still another interesting article in Part Five is the one on the `money illusion' written by E. Shafir, P. Diamond, and A. Tversky, and which first appeared in publication in 1997. The term `money illusion' is used to refer to the tendency of some individuals to think in terms of nominal values instead of real monetary ones. It is thus at odds to the picture offered by classical economics with its assumption of perfect rationality. The authors point to studies in cognitive psychology that indicate that some individuals form alternative representations of identical situations, and that these lead therefore to different responses. Examples of this are given, leading the authors to assert that the money illusion can be interpreted as a bias in assessing the real value of an economic transaction. This bias is induced by a nominal evaluation and its magnitude is determined by the real salience between the nominal and real representations, and the sophistication of the decision maker. The reviewer has used these types of considerations in modeling home equity markets.
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