Can Prospect Theory Be Used to Predict an Investor's Willingness to Pay?
University of Muenster - Finance Center Muenster
University of Kiel - Faculty of Economics and Social Sciences
University of Muenster - Finance Center
January 26, 2013
Journal of Banking and Finance, Vol. 37, No. 6, 2013
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, G20Accepted Paper Series
Date posted: February 20, 2012 ; Last revised: May 19, 2013
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