Prospect theory and utility theory: Temporary versus permanent attitude toward risk

Prospect theory (PT), which relies on subjects’ behavior as observed in laboratory experiments, contradicts the behavior predicted by the Expected Utility (EU) paradigm. Having wealth of $100,000 or having wealth of $90,000 and winning $10,000 in a lottery is the same by EU paradigm but not the same by Markowitz (1952) and by PT (1979) which emphasizes the importance of change of wealth rather than total wealth on welfare. In this study, we resolve this contradiction by introducing the concept of temporary attitude toward risk (TATR) and permanent attitude toward risk (PATR). Using these concepts, we build a model that merges both the PT and the EU paradigms. The TATR and PATR concepts explain recent experimental findings and the observed stock price overreaction. We show that a positive risk premium with decreasing absolute risk aversion (DARA) can be consistent with the S-shaped value function used in PT.

► We build a model that combines the prospect theory and the utility theory.
► We resolve the contradiction between the PT and UT by introducing the concept of temporary attitude toward risk and permanent attitude toward risk.
► This approach explains recent experimental findings and the observed stock price overreaction.
► We show that a positive risk premium with decreasing absolute risk aversion (DARA) can be consistent with the S-shaped value function used in PT.