Measuring the time stability of prospect theory preferences

Abstract

Prospect Theory is widely regarded as the most promising descriptive model for decision making under uncertainty. Various tests have corroborated the validity of the characteristic fourfold pattern of risk attitudes implied by the combination of probability weighting and value transformation. But is it also safe to assume stable Prospect Theory preferences at the individual level? This is not only an empirical but also a conceptual question. Measuring the stability of preferences in a multi-parameter decision model such as Prospect Theory is far more complex than evaluating single-parameter models such as Expected Utility Theory under the assumption of constant relative risk aversion. There exist considerable interdependencies among parameters such that allegedly diverging parameter combinations could in fact produce very similar preference structures. In this paper, we provide a theoretic framework for measuring the (temporal) stability of Prospect Theory parameters. To illustrate our methodology, we further apply our approach to 86 subjects for whom we elicit Prospect Theory parameters twice, with a time lag of one month. While documenting remarkable stability of parameter estimates at the aggregate level, we find that a third of the subjects show significant instability across sessions.