Asymmetric Reaction is Rational Behavior

Abstract

DeBondt and Thahler (1995) point out that while von Neumann-Morgenstern (1947) utility functions, the axioms of cardinal utility (Copeland and Weston, 1992), risk aversion, rational expectations, etc., have formed the basis for theories of choice under uncertainty, research in behavioral science, has either compromised these foundations or outright rejected them. For example, although most asset-pricing models assume symmetry in valence and strength of within-moment preferences, Kahenman and Travesky’s prospect theory, and Kahneman, Knetsch and Thaler (1990) empirical findings establishes that a pattern of behavior contrary to rational expectations. Requiring investors to be utility maximizers, and using an approach similar to Scott-Horvath (1980), this paper argues that the finding investors weighing losses more than gains (Kahneman, Knetsch and Thaler, 1990), is in fact the very foundation of rational behavior.

Keywords: Sign Effect, Utility Theory, Valence, Risk Preference, Moments, Risk premia

JEL Classification: D03, D84, G00