Prospect theory in the financial decision-making process: An empirical study of two Argentine universities.
| Autor | de Guevara Cortes, Rogelio Ladron |
-
Introduction
The expected utility theory (EUT) in finance provides the natural point of departure in the analysis of rational choice models for decision-making by individuals in scenarios of uncertainty since most of the theories can be understood as generalizations of this base theory. Before the 1940s, this theory was the dominant model used to describe financial decision-making decisions. At its core, EUT features a rational decision-maker with clear and comprehensive knowledge of the environment, a well-organized system of preferences and excellent technical skills to select optimal solutions. However, Simon (1979) claimed that decision-makers do not optimize but rather "satisfy". The satisficing principle suggests that individuals forgo optimum solutions for a simplified world in search of satisfactory solutions for a more realistic world.
Years later, Behavioural Finance challenges traditional Finance and introduces psychological factors that affect decision-making. In this approach, Tversky and Kahneman (1974) demonstrated that the decision-making process of individuals in situations of uncertainty is affected by the existence of heuristics and cognitive biases. Behavioural Finance advocates believe that investors make decisions at different levels of rationality or satisfaction, according to Mullainathan and Thaler (2000), and individuals should realize the importance of understanding the notion of bounded rationality, as indicated by Barberis and Thaler (2005). In addition, investor judgment is influenced by factors such as crowd psychology, herd behaviour or unfavourable memory of a prior financial or investment decision. A well-established premise in Behavioural Finance is that investors make decisions according to the principles of prospect theory (PT).
The seminal work by Kahneman and Tversky (1979) advocated this new theory in which individuals deviate from the rationality espoused by classical decision theory and make decisions based on bounded rationality advocated by behavioural decision theory. PT is based on the notion that people are loss averse and are more concerned with losses than gains. Then a new version of prospect theory by Tversky and Kahneman (1992) incorporates the cumulative function and extends the theory to uncertain and risky prospects with any number of outcomes. The resulting model, called cumulative prospect theory (CPT), combines some attractive features of both developments. It gives rise to different evaluations of gains and losses, which are not distinguished in the standard cumulative model, and it provides a unified treatment of both risk and uncertainty.
Kahneman (2003) presents a model in which the fundamental characteristic of investors is not that they reason badly but that they often act intuitively. The behaviour of these agents is not guided by what they can calculate but by what they happen to see at a given moment. He performs an analysis in which he differentiates between two ways of thinking and deciding that correspond to the usual concepts of reasoning and intuition. Whereas reasoning is done deliberately and with great effort, intuitive thinking seems to present itself spontaneously to the mind, without conscious calculation or searching and without effort. Later appeared the third-generation prospect theory (TGPT), which explains choices and judgments of the highest buying and lowest selling prices of risky prospects. This theory combines cumulative prospect theory for risky prospects with the theory that judged values are based on the integration of price paid or price received with the consequences of gambles (Birnbaum, 2018).
This research aims to provide empirical evidence for using the prospect theory's basic assumptions in the Argentine context. Mainly, we analyse the financial decision-making process in students of the economic-administrative academic area of two universities, one public, the National University of Cordoba (UNC), and one private, the Catholic University of Cordoba (UCC), both in the city of Cordoba, Argentina. In that context, this study represents an extension of previous research where similar experiments were conducted in different universities in Mexico, Brazil and Colombia. The nature of this extension responds to our interest in analysing if the financial decisions taken by the participants are different, responding to geographic, cultural, social and economic particularities in each university and country. Despite the PT and Behavioural Finance studies dating from the late 1970s, their development in emergent markets, particularly, Latin America, is scarce. Thus, the main contribution of this paper is to provide additional empirical evidence of the financial decisionmaking process in another geographic, cultural, social and economic context different from previous research that allows us to contribute to the generalizations of the framework of these alternative financial and economics approaches under the light of the scope and limitations of this study.
On the other hand, investment and financing decisions in different economies are essential in the economic development of the regions. In this context, in September 2015, world leaders adopted a set of global goals to eradicate poverty, protect the planet and ensure prosperity for all as part of a new sustainable development agenda. Each objective has specific goals to achieve. Objective No. 17 (SDG) is associated with strengthening the means of implementation and revitalizing the Global Alliance for Sustainable Development, Sustainable Finance and Financial Inclusion as a relevant aspect.
For this reason, this research relates to the aspect of financial decision-making by obtaining empirical evidence from undergraduate and graduate students who have training in economics as input to know how to proceed and adequate the programmes of study in the context of the sustainable development objectives addressed in the agenda proposed by the United Nations Organization (2015). Kahneman and Klein (2009) report on an effort to explore the differences between two approaches to intuition and expertise that are often viewed as conflicting: heuristics and biases and naturalistic decision-making. Starting from the obvious fact that professional intuition is sometimes marvellous and sometimes flawed, the authors attempt to map the boundary conditions that separate actual intuitive skill from overconfident and biased impressions. They conclude that evaluating the likely quality of an intuitive judgment requires an assessment of the environment's predictability. The judgment is made of the individual's opportunity to learn the regularities of that environment. Subjective experience is not a reliable indicator of judgment accuracy.
This document is structured as follows: Section 2 presents the literature review, Section 3 explains the methodological aspects and Section 4 shows this research's empirical results. Finally, Sections 5 and 6 present the discussion and some conclusions, respectively.
-
Literature review
The theoretical framework has been developed, from the most general to the most specific topics addressed in the investigation and answering consistent arguments to support the hypotheses presented. Firstly, we talk about classic economics and then present Behavioural Finance studies. Secondly, because of our content analysis and feature identification, we effectively provide a specific literature review of an individual's decision-making process.
Agudelo (2022) mentions that academic studies in Traditional Economy and Finance assume that people behave when making their decisions as "Homo Economicus", that is, they objectively weigh the options and possible contingencies, they do not ignore the relevant information, do not rush to conclude prematurely and do not allow themselves to be influenced by emotions. However, it is known that this is not a realistic description of the individuals.
Ricciardi (2008) asserts that since the mid-1970s, hundreds of academic studies have been conducted in risk perception-oriented research within the social sciences in various branches of learning. A significant issue within the risk perception literature is how an investor processes information and the various Behavioural Finance theories and issues that can influence a person's perception of risk within the judgment and choice processes. The different Behavioural Finance theories and concepts that influence an individual's risk perception for different types of financial services and investment products include heuristics, overconfidence, prospect theory, loss aversion, representativeness, framing, anchoring, familiarity bias, perceived control, expert knowledge, feelings and concern, among others.
Based on that, Muhammad et al. (2020) argue that there are varying behaviours of decision-makers included in the framework of Behavioural Finance, like heuristics (representativeness, overconfidence, anchoring and gambler fallacy) and prospects behaviours (loss aversion and regret aversion). It also believes that personality characteristics are an integral part of investment decision-making (feelings, moods and ecological factors) because different personalities are different in the decision-making process.
Based on the assumption that people present risk aversion and are entirely rational, that decision-making subjects effectively process all information and that markets are efficient, the individuals make decisions to maximise expected utility. However, criticism of the current paradigm by several studies led to the emergence of a new financial theory: Behavioural Finance, based on the premise, therefore, that decision-makers do not behave in a strictly rational way but make judgments and choices under the influence of emotional aspects, using mental shortcuts or simplifying rules that can lead to systematic errors and deviations, considered cognitive biases.
PT is a more...
Para continuar leyendo
Solicita tu pruebaCOPYRIGHT GALE, Cengage Learning. All rights reserved.
