Absolute vs. Relative Notion of Wealth Changes
9 Pages Posted: 17 Sep 2009 Last revised: 4 Sep 2011
Date Written: September 16, 2009
This paper discusses solutions derived from lottery experiments using two alternative assumptions: that people perceive wealth changes as absolute amounts of money; and that people consider wealth changes as a proportion of some reference value dependant on the context of the problem under consideration. The former assumption leads to the design of Prospect Theory, the latter - to a solution closely resembling the utility function hypothesized by Markowitz (1952B). This paper presents several crucial arguments for the latter approach. That essentially all financial theories consider “returns” expressed in relative terms, rather than “gains” and “losses” expressed as monetary amounts, is one of them. This provides arguments for rejecting the Prospect Theory paradigm.
Keywords: Prospect/Cumulative Prospect Theory, Probability Weighting Function, Markowitz Hypothesis, Relative Utility Function, Weber’s Law, Decision Making Under Risk
JEL Classification: C91, D03, D81, D87
Suggested Citation: Suggested Citation