Randomized Strategies and Prospect Theory in a Dynamic Context

Abstract

When prospect theory (PT) is applied in a dynamic context, the probability weighting component brings new challenges. We study PT agents facing optimal timing decisions and consider the impact of allowing them to follow randomized strategies. In a continuous-time model of gambling and optimal stopping, Ebert and Strack (2015) show that a naive PT investor with access only to pure strategies never stops. We show that allowing randomization can significantly alter the predictions of their model, and can result in voluntary cessation of gambling.

Keywords: Behavioral economics, prospect theory, probability weighting, randomized strategies

JEL Classification: D03, D81, G02