Can Prospect Theory Be Used to Predict an Investor's Willingness to Pay?

Abstract:     
Cumulative prospect theory (CPT) is widely considered to be the most successful descriptive theory for decision making under risk and uncertainty. Sophisticated methods have been developed to reliably elicit CPT parameters on an individual basis. The aim of this paper is to analyze whether such methods are suited to be applied in real world situations, particularly in the context of investment counseling for retail investors. Specifically, we examine whether CPT parameters elicited via standardized computer tools are successful in predicting an individual’s preference for different structured financial products. Surprisingly, we find only low predictive power of the elicited CPT parameters on the WTP. Using a second set of experiments, we examine possible explanations for the low prediction quality. Overall, we have to conclude that it is too much of a leap to draw conclusions about the attractiveness of complex financial products from CPT parameters elicited via simple lotteries.

Keywords: Cumulative prospect theory, Preference elicitation, Retail investor, Behavioral finance, Structured financial product

JEL Classification: C91, D11, D81, G20

Accepted Paper Series