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Stability of risk preferences and the reflection effect of prospect theory

  • Mathematics


Theory Dec. (2010) 68:193–211 DOI 10.1007/s11238-009-9153-3 Stability of risk preferences and the reflection effect of prospect theory Manel Baucells · Antonio Villasís Published online: 27 May 2009 © The Author(s) 2009. This article is published with open access at Abstract Are risk preferences stable over time? To address this question we elicit risk preferences from the same pool of subjects at two different moments in time. To interpret the results, we use a Fechner stochastic choice model in which the revealed preference of individuals is governed by some underlying preference, together with a random error. We take cumulative prospect theory as the underlying preference model (Kahneman and Tversky, Econometrica 47:263–292, 1979; Tversky and Kahneman, Journal of Risk and Uncertainty 5:297–323, 1992). We observe that the aggregate pattern of preferences is very similar in both sessions, and it matches the results reported in the literature. Most subjects are risk averse for gains, and risk seeking for losses. However, the subjects that jointly agree with the reflection effect of prospect theory are around 50%. The percentage of individuals that change their responses across sessions is quite high, 63%. Estimating the stochastic choice model we find that 72% of the subjects have an underlying preference which agrees with the reflec- tion effect of prospect theory. The remaining 28% are mainly classified as risk averse for both gains and losses. The results reinforce the empirical validity of the reflection effect. Deviations from the reflection effect can be attributed to noise, as well as to the existence of a fraction of risk averse subjects. Keywords Reflection effect · Risk preferences · Stability of preferences This paper is part of the Ph.D. thesis of Antonio Villasís. M. Baucells (B) IESE Business School, Barcelona, Spain e-mail: [email protected] A. Villasís IDE Escuela de Dirección de Empresas, Quito, Ecuador e-mail: [email protected] 123

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