Expected Utility Theory

Introduction
• While the earlier literature on finance considered psychological
influences, since 1950s the fi eld of finance has been dominated by
the rational model which assumes individuals are rational and
markets are efficient.
• The rational fi nance model has led to remarkable advances in the
theory and practice of finance. However, it has its limitations as
pointed out by the burgeoning literature on behavioural finance.
Introduction
• Expected utility theory is concerned with people’s preferences with respect to
choices that have uncertain outcomes (gambles).
• According to this theory, if certain axioms are fulfilled, the subjective value of a
gamble for an individual is the statistical expectation of the values thein dividual
assigns to the outcomes of that gamble.
• Certain conditions have to be satisfied for an individual to have rational
preferences.
• To understand these conditions, let us introduce some notation. Suppose an
individual is faced with a choice between two outcomes, A and B.
• The symbol > indicates strong preference, thus A > B means that A is always
preferred to B. The symbol ~ indicates indifference so that A ~ B means the
individual values the two outcomes equally. Finally, the symbol ≥ suggests weak
preference, so that A ≥ B means that the individual prefers A or is indifferent
between A and B.
The von Neumann-Morgenstern Axioms
• According to expected utility theory, the following axioms defi ne a
rational decision maker.
• These axioms are referred to as von Neumann-Morgenstern axioms
as they were laid down by John von Neumann and Oskar
Morgenstern.
• Completeness The individual has well defined preferences and can
always choose between any two alternatives:
• Axiom: For every A and B either A > B or A ≤ B
• In words, the individual either prefers A to B, or is indifferent between A and
B, or prefers B to A.
The von Neumann-Morgenstern Axioms
• Transitivity As an individual decides according to the completeness
axiom, the individual also decides consistently.
• Axiom: For every A, B and C with A ≥ B and B ≥ C we must have A ≥
C.
• In words, if the individual prefers, A to B, and B to C, then he must
prefer A to C.
• Independence If two gambles are mixed with a third one, the
individual will maintain the same preference order as when the two
are presented independently of the third one.
• Axiom: Let A, B and C be three lotteries with A ≥ B, and let t Є (0,
1); then t A + (1 – t) C > t B + (1 – t) C.
The von Neumann-Morgenstern Axioms
• Continuity When there are three lotteries (A, B, C) and the individual
prefers A to B and B to C, then it should be possible to mix A and C in such
a manner that the individual is indifferent between this mix and the lottery
B.
• Axiom: Let A, B and C be lotteries with A ≥ B ≥ C; then there exists a probability p
such that p A + (1 – p) C is equally good as B.
• Omission of Irrelevant Alternatives The individual ignores irrelevant
alternatives in deciding between alternatives. For example, in evaluating
two (or more) alternatives, the individual ignores outcomes that occur with
equal probability under both alternatives being considered.
• Frame Independence The individual cares only about outcomes and the
probabilities with which they occur and not how they are presented or
bundled.
Utility Maximisation
• Utility reflects the satisfaction derived from a particular outcome –
ordinarily an outcome is represented by a “bundle” of goods.
• The utility function, denoted as U(*) assigns numbers to possible outcomes
such that preferred choices are assigned higher numbers.
• Suppose you have to choose between two sandwiches plus one chocolate
bar or one sandwich plus two chocolate bars.
• If you prefer the latter, it means that:
• U(1 sandwich, 2 chocolate bars) > U (2 sandwiches, 1 chocolate bar)
• Note that numerical values have not been assigned to U(*) so far. This is
because the ordering of outcomes by a utility function is what really
matters. A rational individual will consider all possible bundles of goods
that satisfy his budget constraint and then choose the bundle that
maximises his utility
Utility Maximisation
• When only a single good is being considered, then ranking under
certainty is simple. Given the principle of non-satiation, the more the
better. As an example, consider the utility of wealth.
• Mathematically, the utility of wealth can be defined in various ways.
One of the mathematical functions commonly used is the logarithmic
function. This means that the utility derived from wealth w is
• U(w) = ln(w).
• represents this utility function graphically. Note that as wealth
increases, the slope of the utility function gets flatter.
Expected Monetary Value
• In the real world, however, there is a great deal of uncertainty about
outcomes.
• For long, mathematicians had assumed that gambles are assessed by
their expected monetary value (EMV). For example, the EMV of a
gamble which pays 10,000 with a probability of 0.70 and 1000 with a
probability of 0.3 is:
• 0.7 × 10,000 + 0.3 × 1,000 = 7300
• In 1713, Nicholas Bernoulli exposed the weakness of the EMV
criterion. He asked what is the value of a gamble that pays two
pounds if you toss a coin and it comes up head once, or four pounds
if it comes up heads twice in a row, or eight pounds if it come up
heads thrice in a row, so on and so forth? The expected value of such
a gamble is:
• (1/2 × 2) + (1/4 × 4) + (1/8 × 8) + … = 1 + 1 + 1 … = 
• This seems crazy because no one would pay that much for such a
gamble
Daniel Bernoulli’s Solution
• Daniel Bernoulli, a younger cousin of Nicholas Bernoulli, suggested a
solution to that problem 25 years later in 1738 and published it in the St.
Petersburg Journal (that is why it was called St. Petersburg paradox)
• Daniel Bernoulli pointed out that people do not evaluate gambles by their
EMV. He observed that most people abhor risk and hence, choose a sure
thing that is less than expected value. In effect, people are willing to pay a
premium to avoid the uncertainty.
• His reasoning was simple: people’s choices are based on psychological
values of outcomes (utilities) and not dollar values. The psychological value
of a gamble is the average of the utilities of various possible outcomes,
each weighted by its probability; it is not the weighted average of possible
dollar outcomes.
Daniel Bernoulli’s Solution
• Daniel Bernoulli argued that diminishing marginal value of wealth is what explains risk
aversion. Here is an example of diminishing marginal value of wealth.

• You can see that adding 1 million to a wealth of 1 million yields an increment of 8 units of
utility, but adding 1 million of wealth to a wealth of 6 million adds only 3 units of utility.
• Consider the following choice:
• Have 4 million with certainty → Utility: 31
• Equal chance to have 2 million or 6 million → Utility: (18 + 40)/2 = 29
• The expected value of the “sure thing” and the gamble are the same (4 million) but the
utility of the “sure thing” is more.
Daniel Bernoulli’s Solution
• Daniel Bernouilli offered a solution to the famous “St. Petersburg
paradox.” More important,his analysis of risk attitudes in terms of
preferences for wealth is still part of economic analysis even after
almost 300 years.
Expected Utility
• Developed by John von Neumann and Oskar Morgenstern, expected utility
theory attempts to defi ne rational behaviour in face of uncertainty.
• It is a normative theory as it prescribes how people should behave
rationally.
• A positive theory, on the other hand, describes how people actually
behave.
• Expected utility theory is really a theory that deals with risk, not
uncertainty. A risky situation is one where the possible outcomes are
defined with well-defined probabilities associated with them. An uncertain
situation is one where you cannot assign probabilities or define the list of
possible outcomes
Expected Utility
• For all practical purposes, decision-making under risk is concerned with
wealth.
• Suppose there are two states of the world. If the first state occurs your
wealth will be Rs. 1,000,000 and if the second state occurs your wealth will
be Rs. 5,000,000.
• The probabilities associated with these two levels of wealth are 0.3 and
0.7. In formal terms, a prospect is a series of wealth outcomes, with well-
defined probabilities associated with them.
• The above prospect, let us call it P1, can be represented in the following
format.
• P1 (0.3, Rs.1,000,000, Rs. 5,000,000)
Expected Utility
• When there are two outcomes, as in the above case, the fi rst number is the probability of the
first outcome (the probability of the second outcome will be the complementary probability),
• and the next two numbers represent the two possible outcomes. If only one rupee figure is given,
as in P(0.4, `1,500,000), it means that the second outcome is “0”.
• The expected utility of a prospect is calculated as follows:

• where U(P) is the expected utility of the prospect, pi is the probability associated with the ith
• possible outcome, Oi is the ith possible outcome, and U(Oi) is the utility of Oi.
• To illustrate, the expected utility of P1 is:
• U(P1) = 0.3U (1,000,000) + 0.7U(5,000,000)
• If the utility of wealth is defined by a logarithmic function, the expected utility of P1 is:
• U(P1) = 0.3 (4.6052) + 0.7 (6.215) = 1.382 + 4.351 = 5.733
Risk Attitude
• There is ample evidence that, in general, people are risk averse. However,
they are willing to assume risk, if they are compensated for the same.
Suppose stocks A and B offer the same expected return, but stock B is
riskier than stock A. If you are like most people, you would choose stock A.
To invest in stock B, you will ask for a higher expected return so that you
are compensated for bearing higher risk.
• The risk attitude of a person is reflected in his utility function. Going back
to P1, we find that the expected value of wealth is:
• E(W) = 0.3 (1,000,000) + 0.7 (5,000,000) = 3,800,000 = E(P1)
• It may be noted that the expected value of wealth is the same as the
expected value of the prospect. The utility of this expected value of wealth
is:
• U[E(W)] = ln [3,800,000] = U[E(W)] = ln [380] = 5.940
Risk Attitude
• The expected utility of the prospect, U(P1), as we saw before is 5.733. So,
in this case, we find that:
• U[E(W)] > U[P1]
• Thus, if a person’s utility of wealth is described by a logarithmic function,
he would prefer the expected value of a prospect to the prospect itself.
• Such a person dislikes risk and we say that he is risk-averse.
• In general, if a person has a concave utility function (logarithmic utility
function, is an example of a concave utility function), he is risk-averse.
• For such a person, U[E(P)] > U(P)
• A risk-averse person would have the expected value of the prospect with
certainty rather than take a gamble for an uncertain outcome.
Risk Attitude
• A risk-averse person would be willing to
sacrifice something for certainty. The
certainty equivalent of a prospect is the
certain level of wealth which makes the
decision maker indifferent between the
prospect and that certain level of wealth.
• The certainty equivalent of P1, given the
logarithmic utility function, is Rs. 3,088,900.
• As in Figure on the right shows, a wealth of
308.89 (in Rs. 10,000s) provides a utility that
equals the expected utility of P1.
Risk Attitude
• U[308.89] = U[P1] = 0.3 (4.6052) + 0.7 (6.215) = 5.733
• Thus, in this case the decision maker considers a certain
amount of `3,088,900 as equivalent to P1.
• Generally, people are risk-averse, but some people like
risk. Such people are called risk seekers. The utility
function of a risk seeker is convex, as in:
• U[P] > U[E(P)]
• This means that the utility of prospect is greater than
the utility of the expected value of the prospect. Figure
2 shows the utility function of a risk seeker. Thus, a risk
seeker would prefer a gamble on an uncertain outcome
rather than take the expected value of the prospect with
certainty.
• Finally, some people are risk-neutral—they lie between
risk averters and risk seekers. They care only about
expected values as risk does not matter to them. For a
risk-neutral individual:
• U[E(P)] = U[P]
Risk Attitude
• For a risk-neutral individual, the utility of the
expected value of the prospect is equal to the
expected utility of the prospect.
• This means that the utility function for a risk-
neutral individual is a straight line as Figure 3.
• In our previous example, a risk-neutral
individual would be indifferent between a
prospect with a 30% chance of wealth of
`1,000,000 and 70% chance of wealth of
`5,000,000 and a wealth of `3,800,000 with
certainty.
Example 1
Example 2
Allais Paradox
• Designed by Maurice Allais, a Nobel laureate in economics, the Allais
paradox shows an inconsistency between actual observed choices
and the predictions of expected utility theory.
• Consider the two situations shown in Table.
• In situation 1, people can choose between Prospect A and Prospect
A*, and in Situation 2, people can choose between B and B*.
Allais paradox
• When these situations are presented to many people, a large number
of people choose A over A* in Situation 1 and B* over B in Situation 2.
It can be demonstrated that such preferences violate expected utility
theory.
Allais paradox
• If utility theory is used to rank outcomes, a preference for A over A* means U(A) > U(A*).
• According to utility theory
• U(A) = U($1,000,000)
• U(A*) = 0.89U ($1,000,000) + 0.1U($5,000,000)
• U(A) > U(A*), means
• U($1,000,000) > 0.89U($1,000,000) + 0.1U($5,000,000)
• Simplifying this, we get:
• 0.11U($1,000,000) > 0.1U($5,000,000)
• Similarly, if expected utility theory holds, a preference for B* over B, implies:
• 0.1U($5,000,000) > 0.11U($1,000,000)
• This is inconsistent with the earlier result and this inconsistency is referred to as the Allais
• paradox.
MODERN PORTFOLIO THEORY
Risk and Return for Individual Assets
Modern portfolio theory assumes that investors are risk averse and
preferences (utilities) are defined in terms of the mean and variance of
returns.
The return on a risky asset is considered as being a random variable
which is normally distributed. This means that the return of an asset for
the next period is determined by a probability distribution that is
described by two parameters, viz, expected value and variance (or its
square root; standard deviation).
With n observations of the historical return of asset i, the mean return
is computed as follows:
MODERN PORTFOLIO THEORY
• Risk and Return for Individual Assets
where Ri is the mean return on asset i, Ri,t is the return on asset i during the
t th period, and n is the number of periods over which historical return data
is gathered.
The sample variance of returns, σi2 is computed as follows:

Example: R1 = 15%, R2 = 12%, R3 = 20%, R4 = –10%, R5 = 14%, and R6 = 9%

MODERN PORTFOLIO THEORY
• Rate of return = Dividend yield + Capital gain yield

• R 1 is the rate of return in year 1, DIV1 is dividend per share received in

year 1, P0 is the price of the share in the beginning of the year and P1 is
the price of the share at the end of the year. Dividend yield is the
percentage of dividend income, and it is given by dividing the dividend per
share at the end the year by the share price in the beginning of the year;
that is, DIV 1/P0
Expected Rate of Return
• The expected rate of return [E(R)] is the sum of the product of each
outcome (return) and its associated probability:

• Expected rate of return = rate of return under scenario 1 × probability

of scenario 1 + rate of return under scenario 2 × probability of
scenario 2 +… + rate of return under scenario n × probability of
scenario n

E(R) = R1 × P1 + R2 × P2 + ... + Rn Pn
• The expected rate of return is the average return. It is 6 per cent in
our example. We know that the possible outcomes range between –6
per cent to +18.5 per cent.
• How much is the average dispersion?
It can be explained by the variance or the standard deviation
• The following formula can be used to calculate the variance of
returns:
σ2 = [R1 – E (R)]2 P1 + [R2 – E(R)]2 P2 + ... + [Rn – E(R)]2Pn
PORTFOLIO RETURN: TWO-ASSET CASE
• The return of a portfolio is equal to the weighted average of the
returns of individual assets (or securities) in the portfolio with
weights being equal to the proportion of investment value in each
asset.
• Expected return on portfolio = weight of security X × expected return
on security X + weight of security Y × expected return on security Y
Example
PORTFOLIO RISK: TWO-ASSET CASE
• risk of a portfolio could be measured in terms of its variance
or standard deviation.
• The portfolio return is the weighted average of returns on individual
assets. Is the portfolio variance or standard deviation a weighted
average of the individual assets’ variances or standard deviations? It is
not. The portfolio variance or standard deviation depends on the co-
movement of returns on two assets
covariance of returns of the two securities
Variance and Standard Deviation of a Two-
Asset Portfolio
Example 2
Efficient Frontier for the n-Security Case
 Riskless Lending and Borrowing
• Suppose that investors can also lend and borrow money at a risk-free
rate of Rf
Line II is the tangent to the efficient set of risky
securities, so it provides the investor the best possible
opportunities. You can see that line II dominates line I—
for that matter, it dominates any other line between Rf
and any point in the feasible region of risky securities.

For efficient portfolios (which includes the market

portfolio), the relationship between risk and return is
depicted by the straight line Rf SG. The equation for this
line, called the capital market line (CML), is:

Given that the market portfolio has an expected return of E(RM)

and standard deviation of σM, the slope (price of risk) of the
CML can be obtained as follows:
CAPITAL ASSET PRICING MODEL (CAPM)
• The capital asset pricing model (CAPM) provides a framework to
determine the required rate of return on an asset and indicates the
relationship between return and risk of the asset.
• The required rate of return specified by CAPM helps in valuing an
asset. One can also compare the expected (estimated) rate of return
on an asset with its required rate of return and determine whether
the asset is fairly valued.
Assumptions of CAPM
CAPM provides a framework to price individual securities and determine the required rate of return for
individual securities.
• Market efficiency The capital market efficiency implies that share prices reflect all available information.
Also, individual investors are not able to affect the prices of securities. This means
that there are large numbers of investors holding a small amount of wealth.
• Risk aversion and mean-variance optimization Investors are risk-averse. They evaluate a security’s return
and risk, in terms of the expected return and variance or standard deviation
respectively. They prefer the highest expected returns for a given level of risk. This implies
that investors are mean-variance optimizers and they form efficient portfolios.
• Homogeneous expectations All investors have the same expectations about the expected returns and risks
of securities.
• Single time period All investors’ decisions are based on a single time period
• Risk-free rate All investors can lend and borrow at a risk-free rate of interest. They form portfolios from
publicly traded securities like shares and bonds
Characteristics Line
• sensitivity coefficient or index.
• The sensitivity coefficient is called beta
• The slope of the characteristics line is the sensitivity coefficient
Security Market Line (SML)
• Under CAPM, the risk of an individual risky security is defined as the
volatility of the security’s return vis- á-vis the return of the market
portfolio.
• This risk of an individual risky security is its systematic risk. Systematic
risk is measured as the covariance of an individual risky security with the
variance of the market portfolio.
• The security market line (SML) shows the
Expected return of an individual asset given its risk.
Security Market Line (SML)
• The covariance of any asset with itself is represented by its variance (covj, j)
= σ2j).
• The return on market portfolio should depend on its own risk, which is
given by the variance of the market return (σ2m).
• Therefore, the risk-return relationship equation is as follows:

• The term, cov j, m/σ2m is called the security beta, βj.

Beta is a standardized measure of a security’s systematic risk
Security Market Line (SML)
• The beta of the market portfolio is 1. The market portfolio is the
reference for measuring the volatility of individual risky securities.
Since a risk-free security has no volatility, it has zero beta.
• We can rewrite the equation for SML as follows
•
Limitations (CAPM)
• CAPM has the following limitations:
It is based on unrealistic assumptions.
It is difficult to test the validity of CAPM.
Betas do not remain stable over time.
EFFICIENT MARKETS HYPOTHESIS
• In the mid-1960s, Eugene Fama introduced the idea of an “effi cient”
capital market to the literature of financial economics.
• Put simply, the idea is that the intense competition in the
capital market leads to fair pricing of debt and equity securities
• An efficient market is one in which the market price of a security is an
unbiased estimate of its intrinsic value. Note that market efficiency does
not imply that the market price equals intrinsic value at every point in time.
All that it says is that the errors in the market prices are unbiased.
• This means that the price can deviate from the intrinsic value but the
deviations are random and uncorrelated with any observable variable.
• If the deviations of market price from intrinsic value are random, it is not
possible to consistently identify over or under-valued securities.
Misconceptions about the Efficient Markets
Hypothesis
• Misconception 1: The efficient markets hypothesis implies that the
market has perfect forecasting abilities.
• Answer: The efficient markets hypothesis merely implies that prices impound
all available information. This does not mean that the market possesses
perfect forecasting abilities.
• Misconception 2: As prices tend to fluctuate, they would not reflect
fair value.
• Answer: Unless prices fluctuate, they would not reflect fair value. Since the
future is uncertain, the market is continually surprised. As prices reflect these
surprises, they fluctuate.
Misconceptions about the Efficient Markets
Hypothesis
• Misconception 3: Inability of institutional portfolio managers to
achieve superior investment performance implies that they lack
competence.
• Answer: In an efficient market, it is ordinarily not possible to achieve superior
investment performance. Market efficiency exists because portfolio managers
are doing their job well in a competitive setting
• Misconception 4: The random movement of stock prices suggests
that the stock market is irrational
• Answer: Randomness and irrationality are two different matters. If investors
are rational and competitive, price changes are bound to be random
AGENCY THEORY
• In proprietorships, partnerships, and cooperative societies, owners are
actively involved in management.
• But in companies, particularly large public limited companies, owners
typically are not active managers.
• Instead, they entrust this responsibility to professional managers who may
have little or no equity stake in the firm.
• While there are compelling reasons for separation of ownership and
management, a separated structure leads to a possible conflict of interest
between managers (agents) and shareholders (principals).
• Though managers are the agents of shareholders, they are likely to act in
ways that may not maximise the welfare of shareholders.
AGENCY THEORY
• In practice, managers enjoy substantial autonomy and hence have a natural
inclination to pursue their own goals.
• To prevent from getting dislodged from their position, managers may try to
achieve a certain acceptable level of performance as far as shareholder welfare is
concerned.
• However, beyond that their personal goals like presiding over a big empire,
pursuing their pet projects, diminishing their personal risks, and enjoying
generous compensation and lavish perquisites tend to acquire priority over
shareholder welfare.
• The lack of perfect alignment between the interests of managers and
shareholders results in agency costs which may be defined as the difference
between the value of an actual firm and value of a hypothetical fi rm in which
management and shareholder interests are perfectly aligned.
PROSPECT THEORY
• Key Tenets of Prospect Theory
• The key tenets of prospect theory are:
1. Reference dependence
2. Diminishing sensitivity
3. Loss aversion
4. Changes in risk attitude
5. Decision weights
• For discussing the tenets, we will use the notation introduced in Chapter 2.
Recall that a prospect P(pr, A, B) is a gamble whose outcomes are A (with a
probability of pr) and B (with a probability of (1 – pr)).
• If the second outcome is omitted, as in P (pr, A), it means that it is zero.
Finally, if the probability also is omitted, as in P(A), it means that it is a
certain (riskless) prospect.
PROSPECT THEORY
• Reference Dependence The value of a prospect depends on gains and
losses relative to a reference point, which is usually the status quo.
• Consider the following decision situations:
• Decision Situation 1: Assume that you are richer by ` 3,000 than you
are today, and then choose between P1 (` 1,000) and P2 (0.50, `
2,000)
• Decision Situation 2: Assume that you are richer by ` 5,000 than you
are today, and then choose between P3 (–` 1,000) and P4 (0.5, `
2,000)
PROSPECT THEORY
• You can see that the two situations are effectively the same. In both
of them, the decision is between a certain ` 4,000 and a prospect
which has two payoffs, ` 3,000 and ` 5,000, with equal probabilities.
Yet, respondents typically choose P1 and P4.
• This means that in decision situation 1 they shun risk, whereas in
decision situation 4, they seek risk.
• The risk attitude is not the same across gains and losses because what
matters to people is not the level of wealth, but the change in wealth.
People typically evaluate an outcome in terms of gain or loss, relative
to a reference point, which is usually the current wealth
PROSPECT THEORY
• Note that in the above problem, the two decision situations assume
different starting wealth position.
• An important difference between expected utility theory and prospect
theory is that the former assumes that people value an outcome based on
the final wealth position, regardless of the initial wealth, whereas the latter
assumes that people value an outcome in terms of gain or loss relative to a
reference point, which is usually the current wealth.
• The utility function of a rational person as per expected utility theory is
shown in Panel A of Figure.
• According to this description, higher wealth provides higher satisfaction or
“utility,” but at a diminishing rate. This results in risk aversion. The increase
in utility from a gain of ` 10,000 is less than the decrease in utility from a
loss of ` 10,000.
PROSPECT THEORY
• The prospect theory
provides an alternative
description of
preferences.
• According to prospect
theory, utility (referred to
as value) depends not on
the level of wealth as in
Panel A, but on changes
in wealth from current
levels as in Panel B of
Figure.
PROSPECT THEORY
• Diminishing Sensitivity:
• How do people value gains/losses? They value gains/losses according
to an S-shaped value function as shown in Panel B.
• Notice the following features of the value function
• The value function is concave for gains. This means that people feel good when they gain, but twice the gain
does not make them feel twice as good. The concavity over gains means that people tend to be risk-averse
over moderate probability gains: they prefer a certain gain of 1000 to a 50 per cent chance of 2000.
• The value function is convex for losses. This means that people experience a pain when they lose, but twice
the loss does not mean twice the pain. The convexity (or diminishing sensitivity) over losses means that
people tend to be risk–seeking over losses: they prefer a 50 per cent chance of losing 2000 to losing 1000 for
sure. While the convexity of the value function over losses captures an important facet of preference, it
ignores another. A person facing a loss that represents a large fraction of wealth tends to be very sensitive,
not insensitive, to further losses.
PROSPECT THEORY
• Loss Aversion The value function is steeper for losses than for gains.
• This means that people feel more strongly about the pain from a loss
than the pleasure from an equal gain – about two and half times as
strongly, according to Kahneman and Tversky.
• This phenomenon is referred to as loss aversion. It is quite different
from risk aversion
FRAMING
• Tversky and Kahneman posed simple problems

• The government estimates that 600 people will die due to a deadly
outbreak of Asian flu, if nothing is done. To tackle this problem, the
government is considering two alternative programmes.
• Programme A: Develop a vaccine which can save 200 lives.
• Programme B: Develop a vaccine which will stop anyone from dying
provided it works.
• The probability that it will work is one-third. If it doesn’t work no one will
be cured. When students were asked to choose one of the two
programmes, 75% of them chose programme A. The risk of seeing all 600
victims die was considered too much to be compensated by the hope that
all would be saved.
FRAMING
• Kahneman and Tversky reformulated the question and posed it to a
different group of students. To tackle the same health problem, two
choices were offered:
• Programme C: Accept that 400 victims of the flu will die.
• Programme D: Cure all the 600 victims of the flu with a probability of one-
third.
• When students were asked to choose between these two options, two-
thirds of the students chose programme D. The statement ‘400 would die’
scared most students, even though it is actually the same outcome as that
of programme A above, but expressed in more dire terms. It is evident that
what matters it is not just what you ask, but also how you ask.
MENTAL ACCOUNTING
• Traditional finance holds that wealth in general and money in particular must be
regarded as “fungible” and every financial decision should be based on a rational
calculation of its effects on overall wealth position.
• In reality, however, people do not have the computational skills and will power to
evaluate decisions in terms of their impact on overall wealth. It is intellectually
difficult and emotionally burdensome to figure out how every short-term
decision (like buying a new phone or throwing a party) will bear on what will
happen to the wealth position in the long run.
• So, as a practical expedient, people separate their money into various mental
accounts and treat a rupee in one account differently from a rupee in another
because each account has a different significance to them.
• The concept of mental accounting was proposed by Richard Thaler, one of the
brightest stars of behavioural finance
MENTAL ACCOUNTING
• Mr. and Mrs. Sharma have saved ` 10 lakhs for their daughter’s
wedding that may take place 3 years from now. The money earns
interest at the rate of 9% in a bank fixed deposit account. They just
bought a new car for ` 6 lakhs on which they have taken a
3 year car loan at 12%