Randomized Strategies and Prospect Theory in a Dynamic Context

29 Pages Posted: 29 Nov 2014 Last revised: 6 Jan 2017

Vicky Henderson

University of Warwick

David Hobson

University of Warwick

Alex S. L. Tse

University of Cambridge - Judge Business School

Date Written: January 04, 2017

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

Suggested Citation

Henderson, Vicky and Hobson, David and Tse, Alex S. L., Randomized Strategies and Prospect Theory in a Dynamic Context (January 04, 2017). Available at SSRN: https://ssrn.com/abstract=2531457 or http://dx.doi.org/10.2139/ssrn.2531457

Vicky Henderson (Contact Author)

University of Warwick ( email )

Gibbet Hill Rd.
Coventry, West Midlands CV4 8UW
United Kingdom
44 (0)2476 574811 (Phone)

David Hobson

University of Warwick ( email )

CV4 7AL
United Kingdom

Alex S. L. Tse

University of Cambridge - Judge Business School ( email )

Trumpington Street
Cambridge, CB2 1AG
United Kingdom

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