Accommodating stake effects under prospect theory

Abstract

One of the stylized facts underlying prospect theory is a fourfold pattern of risk preferences. People have been shown to be risk seeking for small probability gains and large probability losses, while being risk averse for large probability gains and small probability losses. Another fourfold pattern of risk preferences over outcomes, postulated by Harry Markowitz in 1952, has received much less attention and is currently not integrated into prospect theory. In two experiments, we show that risk preferences may change over outcomes. While we find people to be risk seeking for small outcomes, this turns to risk neutrality and later risk aversion as stakes increase. We then show how a one-parameter logarithmic utility function fits such stake effects significantly better under prospect theory than the power or exponential functions mostly used when fitting prospect theory models. We further investigate the extent to which the use of ill-suited functional forms to represent utility may result in violations of prospect theory, and whether such violations disappear when using logarithmic utility.