Abstract
Experimental findings and in particular Prospect Theory and Cumulative Prospect Theory contradict Expected Utility Theory, which in turn may have a direct implication to theoretical models in finance and economics. We show growing evidence against Cumulative Prospect Theory. Moreover, even if one accepts the experimental results of Cumulative Prospect Theory, we show that most theoretical models in finance are robust. In particular, the CAPM is intact even if investors make decisions based on change of wealth, employ decision weights, and are risk-seeking in the negative domain.
Access this chapter
Tax calculation will be finalised at checkout
Purchases are for personal use only
References
Allais, M. 1953. Le Comportement de l’homme rationnel devant le risque: Critique des postulates et axioms de l’école Americaine. Econometrica 21: 503–564.
Arrow, K. 1965. Aspects of the theory of risk bearing. Helsinki: Yrjo Jahnssonin Sattio.
Arrow, K.J. 1971. Essays in the theory of risk bearing. Chicago: Markham Publishing Company.
Benartzi, S., and R. Thaler. 1995. Myopic loss aversion and the equity premium puzzle. Quarterly Journal of Economics 110 (1): 73–92.
———. 1999. Risk aversion or myopia? Choices in repeated gambles and retirement investments. Management Science 45 (3): 364–381.
———. 2001. Naive diversification strategies in retirement savings plans. American Economic Review 91 (1): 79–98.
Birnbaum, M.H. 1997. Violations of monotonicity in judgment and decision making. In Choice, decision, and measurement: Essays in honor of R. Duncan Luce, ed. A.A.J. Marley, 73–100. Mahwah: Erlbaum.
Birnbaum, M.H., and W.R. McIntosh. 1996. Violations of branch independence in choices between gambles. Organizational Behavior and Human Decision Processes 67: 91–110.
Black, F., and M. Scholes. 1973. The pricing of options and corporate liabilities. Journal of Political Economy 81: 637–654.
Edwards, W. 1955. The prediction of decisions among bets. Journal of Experimental Psychology 50: 201–214.
———. 1962. Subjective probabilities inferred from decisions. Psychology Review 69: 109–135.
Elton, E.J., and M.J. Gruber. 1984. Modern portfolio theory and investment analysis. 2nd ed. New York: Wiley.
Fama, E.F. 1965. The behavior of stock market prices. Journal of Business 38: 34–105.
———. 1991. Efficient capital markets: II. Journal of Finance 46: 1575–1617.
Fishburn, P.C. 1978. On Handa’s “new theory of cardinal utility” and the maximization of expected return. Journal of Political Economy 86: 321–324.
Friedman, M., and L.J. Savage. 1948. The utility analysis of choices involving risk. Journal of Political Economy 56: 279–304.
Funk, S.G., A. Rapoport, and L.V. Jones. 1979. Investing capital on safe and risky alternatives: An experimental study. Journal of Experimental Psychology: General 108: 415–440.
Gordon, M.J., G.E. Paradis, and C.H. Rorke. 1972. Experimental evidence on alternative portfolio decision rules. American Economic Review 52: 107–118.
Hadar, J., and W. Russell. 1969. Rules for ordering uncertain prospects. American Economic Review 59: 25–34.
Hanoch, G., and H. Levy. 1969. The efficiency analysis of choices involving risk. Review of Economic Studies 36: 335–346.
Kahneman, D., and A. Tversky. 1979. Prospect theory of decisions under risk. Econometrica 47 (2): 263–291.
Kroll, Y., and H. Levy. 1992. Further tests of separation theorem and the capital asset pricing model. American Economic Review 82: 664–670.
Kroll, Y., H. Levy, and A. Rapoport. 1988a. Experimental tests of mean-variance model for portfolio selection. Organizational Behavior and Human Decision Processes 42: 388–410.
———. 1988b. Experimental tests of the separation theorem and the capital asset pricing model. American Economic Review 78: 500–519.
Leshno, M., and H. Levy. 2002. Preferred by “All” and preferred by “Most” decision makers: Almost stochastic dominance. Management Science 48: 1074–1085.
Levy, H. 1992. Stochastic dominance and expected utility: Survey and analysis. Management Science 38 (4): 555–593.
———. 1997. Risk and return: An experimental analysis. International Economic Review 38: 119–149.
———. 1998. Stochastic dominance: Investment decision making under uncertainty. Boston: Kluwer Academic Publishers.
Levy, M., and H. Levy. 2001. Testing the risk-aversion: A stochastic dominance approach. Economics Letters 71: 233–240.
———. 2002a. Prospect theory: Much ado about nothing? Management Science 48: 1334–1349.
———. 2002b. Experimental test of prospect theory value function. Organizational Behavior and Human Decision Processes 89: 1058–1081.
Levy, H., and M. Levy. 2002c. Arrow-Pratt risk aversion, risk premium and decision weights. Journal of Risk and Uncertainty 25: 265–290.
———. 2004. Prospect theory and mean-variance analysis. Review of Financial Studies 17: 1015–1041.
Levy, H., and Z. Wiener. 1998. Stochastic dominance and prospect dominance with subjective weighting functions. Journal of Risk and Uncertainty 16: 147–163.
Levy, M., H. Levy, and S. Solomon. 2000. Microscopic simulation of financial markets: From investor behavior to market phenomena. San Diego: Academic Press.
Lintner, J. 1965. Security prices, risk, and maximal gains from diversification. Journal of Finance 20: 587–615.
Machina, M.J. 1994. Review of generalized expected utility theory: The rank-dependent model. Journal of Economic Literature 32: 1237–1238.
Markowitz, H.M. 1952a. Portfolio selection. Journal of Finance 7: 77–91.
———. 1952b. The utility of wealth. Journal of Political Economy 60: 151–156.
———. 1959. Portfolio selection. New York: Wiley.
———. 1987. Mean variance analysis, portfolio choice and capital markets. New York: Basil Blackwell.
Modigliani, F., and M.H. Miller. 1958. The cost of capital corporation finance and the theory of investment. American Economic Review 48: 261–297.
Odean, T. 1998. Are investors reluctant to realize their losses. Journal of Finance 53: 1775–1798.
Plott, C.R. 1979. The application of laboratory experimental methods to public choice. In Collective decision making, ed. C.S. Russell. Washington, DC: Resources for the Future.
Pratt, J.W. 1964. Risk aversion in the small and in the large. Econometrica 32: 122–136.
Prelec, D. 1998. The probability weighting function. Econometrica 66: 497–527.
Preston, M.G., and P. Baratta. 1948. An experimental study of the auction-value of uncertain outcomes. American Journal of Psychology 61: 183–193.
Quiggin, J. 1982. A theory of anticipated utility. Journal of Economic Behavior and Organization 3: 323–343.
———. 1993. Generalized expected utility theory: The rank dependent model. Boston: Kluwer Academic Publishers.
Rapoport, A. 1984. Effects of wealth on portfolio under various investment conditions. Acta Psychologica 55: 31–51.
Ross, S.A. 1976. The arbitrage theory of capital asset pricing. Econometrica 32: 122–137.
Samuelson, P.A. 1994. The long term case for equities. Journal of Portfolio Management 21: 15–24.
Sharpe, W.F. 1964. Capital asset prices: A theory of market equilibrium under conditions of risk. Journal of Finance 19: 425–442.
Smith, V.L. 1976. Experimental economics: Induced value theory. American Economic Review Proceedings 66: 274–279.
———. 1982. Microeconomic systems as an experimental science. American Economic Review 72: 923–955.
Swalm, R.O. 1966. Utility theory – Insights into risk taking. Harvard Business Review 44: 123–136.
Thaler, H. 1993. Advances in behavioral finance. New York: Russell Sage Foundation.
Thaler, R.H. 1999. The end of behavioral finance. Financial Analysts Journal 55 (6): 12–17.
Tobin, J. 1958. Liquidity preferences as behavior toward risk. Review of Economic Studies 25: 65–86.
Tversky, A., and D. Kahneman. 1981. The framing of decisions and the psychology of choice. Science 211: 453–480.
———. 1992. Advances in prospect theory: Cumulative representation of uncertainty. Journal of Risk and Uncertainty 5: 297–323.
Viscusi, W.K. 1989. Prospective reference theory: Toward an explanation of the paradoxes. Journal of Risk and Uncertainty 2: 235–264.
von Neuman, J., and O. Morgenstern. 1944. Theory of games and economic behavior. Princeton: Princeton University Press.
Wakker, P.P. 2003. The data of Levy and Levy, “Prospect theory: Much ado about nothing?”Actually support prospect theory. Management Science 48: 1334–1349.
Wakker, P.P., I. Erev, and E.U. Weber. 1994. Comonotonic independence: The critical test between classical and rank-dependent utility theories. Journal of Risk and Uncertainty 9: 195–230.
Wilde, L. 1980. In the case of laboratory experiments in economics. In The philosophy of economics, ed. J. Pitt. Dordrecht: Reidel.
Yaari, M. 1987. The dual theory of choice under risk. Econometrica 55 (1): 95–115.
Acknowledgements
The author acknowledges the financial support of the Krueger Center of Finance.
Author information
Authors and Affiliations
Corresponding author
Editor information
Editors and Affiliations
Rights and permissions
Copyright information
© 2022 Springer Nature Switzerland AG
About this entry
Cite this entry
Levy, H. (2022). Experimental Economics and the Theory of Finance. In: Lee, CF., Lee, A.C. (eds) Encyclopedia of Finance. Springer, Cham. https://doi.org/10.1007/978-3-030-91231-4_27
Download citation
DOI: https://doi.org/10.1007/978-3-030-91231-4_27
Published:
Publisher Name: Springer, Cham
Print ISBN: 978-3-030-91230-7
Online ISBN: 978-3-030-91231-4
eBook Packages: Economics and FinanceReference Module Humanities and Social SciencesReference Module Business, Economics and Social Sciences