Until the Bitter End: On Prospect Theory in a Dynamic Context
25 Pages Posted: 16 Feb 2012 Last revised: 15 Dec 2015
Date Written: February 15, 2012
Many economic and financial decisions depend crucially on their timing. People decide when to invest in a project, when to liquidate assets, or when to stop gambling in a casino. We provide a general result on prospect theory decision makers who are unaware of the time-inconsistency induced by probability weighting. If a market offers a sufficiently rich set of investment strategies, then such naïve investors postpone their stopping decisions indefinitely. We illustrate the drastic consequences of this never-stopping result, and conclude that probability distortion in combination with naïveté leads to unrealistic predictions for a wide range of dynamic setups.
Keywords: Behavioral Economics, Disposition Effect, Irreversible Investment, Prospect Theory, Skewness Preference, Time-Inconsistency
JEL Classification: G02, D03, D81
Suggested Citation: Suggested Citation