The Utility of Wealth in an Upper and Lower Partial Moment Fabric

by

Fred Viole OVVO Financial Systems fred.viole@ovvofinancialsystems.com And David Nawrocki Villanova University Villanova School of Business 800 Lancaster Avenue Villanova, PA 19085 USA 610-519-4323 david.nawrocki@villanova.edu

The Utility of Wealth in an Upper and Lower Partial Moment Fabric

ABSTRACT

Utility should be a function consisting of two autonomous sections both positive and negative, that needs to be configurable to the individuals it is designed to represent. This is achieved through the target by which individuals measure their investments against as well as their individual interpretations of target variances. Historical utility functions tend to generalize these distinctions in order to apply them to a broader scope of the population and project a descriptive theory. Instead of the observed fitting the function, we have the function fit the observed in an effort to combine descriptive and normative techniques.

INTRODUCTION - HISTORICAL UTILITY FUNCTIONS

A man who seeks advice about his actions will not be grateful for the suggestion that he maximize his expected utility. Roy(1952)

Almost 60 years later, Roys advice still holds true. However, given the current financial crisis era where risk management failed miserably, the study of utility theory and risk remains paramount. The modern era of utility theory starts with von Neumann and Morgenstern (1944) with their family of utility functions. Their work on the utility of risk was extended with the Reverse S-shaped utility functions of Friedman and Savage (1948) and Markowitz (1952). This was followed by the S-shaped utility functions of prospect theory by Kahneman and Tversky (1979) which forms the basis of the modern behavioral finance discipline. See Figure 1.
Bernouillis Utility Function Friedman-Savages Utility Function

Utility

Dollars Markowitzs Customary-Wealth Utility Theory Utility

Utility

Dollars Kahneman and Tverskys Prospect Theory Utility Function Utility Losses Dollars

Gains

Source: Lopes (1987)

Figure 1. Various historical utility functions, all convex for losses and ultimately concave for gains

However, Roy (1952) made an important contribution with his safety first model where an investor will wish to maintain a subsistence level which translates into disastrous results if the level is not achieved. This idea of a target return benchmark was integrated into utility theory by Bawa (1975) and Fishburn (1977) with their general n-degree lower partial moment (LPM) models which provide us with a workable utility model. The LPM utility functions are linear (risk neutral) above a target return, h. The below target utility is determined by the degree n in the LPM calculation. See Figure 2 where investors are risk averse for n >1, risk neutral for n = 1, and risk seeking for n < 1 for a target return t. Notice that the higher the degree n, the more concave the lower utility function is. The closer n is to zero, the more convex the utility function.

Figure 2. Plots of LPM utility functions for five values of a. Source: Fishburn (1977)

While the LPM model is a very useful advance, Fishburn and Kochenberger (1979) note that many von Neumann and Morgenstern utility function include risk aversion and risk seeking above Roys target return. This idea was extended to the Upper Partial Moment/Lower Partial Moment (UPM/LPM) model by Holthausen (1981). The degree for the UPM allows for risk aversion and risk seeking above the target as shown in Figure 3.1 We see both Reverse S-shaped (=2, =2) and S-shaped (=0.5, =0.5) utility functions in the Figure. Therefore, the

UPM/LPM model is a useful application of the previous utility models by Friedman and Savage (1948), Markowitz (1952), Roy (1952), and Kahneman and Tversky (1979).

Figure 3. Plots of the UPM/LPM Utility Function for k=2 and various , Values. Source: Holthausen (1981)

Holthausen uses the notation for the n-degree LPM and for the degree of the UPM.

Furthermore, Holthausen (1981) provides a proof for the following relationships between first degree (FSD), second degree (SSD), and third degree stochastic dominance (TSD). Note,

however, that SSD and TSD analysis does not include risk seeking (Reverse S-shaped) UPM utility ( > 1) but it is consistent with S-shaped utility functions of prospect theory. FSD contains all UPM/LPM(,,t) rules for all 0, 0. SSD contains all UPM/LPM(,,t) rules for all 1, 0 1 TSD contains all UPM/LPM(,,t) rules for all 2, 0 1 One major result of Holthausens paper is the proof that the --t model is congruent with a von Neumann-Morgenstern utility function of the form: (x t) U(x) =

for all x t for all x t

-k (t x)

where is k is a constant that indicates a kink in the utility function at the target return whenever k >1. Thus, the Holthausen --t model is fully congruent with expected utility theory. Thus, the UPM/LPM model is consistent with more modern utility theories such as Lopes (1987) SP/A theory and the Shefrin and Statman (2000) behavioral portfolio theory. This paper extends the UPM/LPM model to include a multiple UPM/LPM model that contains both positive and negative utility considerations with single and multiple targets.

HYPOTHESIS

All of the above mentioned historical utility functions and related theories share a common trait; they are influenced by the law of diminishing marginal utility, or diminishing sensitivity from a reference point ultimately binding their quantifiable utility. Figure 1, from Shefrin and Statman (2000) graphically presents these historical utility functions. Another evolutionary trait is that utility theories have also become more descriptive over time. What differs among them is the delineation of positive and negative utility with variations on what the target should be for investors. It started off as simple gains and losses as the separation of positive and negative utility and then encompassed the notion of return targets as the singularity. 2 Typically, this singularity would serve the purpose of converting the function from convexity for losses to concavity for gains. In the spirit of the singularity's ability to transform the space time fabric, we propose the computation of two autonomous utility subsets for gains and losses with their own singularities thereby exhibiting both concavity and convexity for both positive and negative utility. The scalable nature of the model allows for multiple singularities or benchmarks, ultimately leading to the individual's personal consumption satiation level for positive utility and their subsistence level for negative utility. The outermost singularity provides the function the ability to shift from concavity to convexity for positive utility. Inner singularities will allow for shifts to alternate utility subsets, while maintaining the prevalent concavity / convexity. Holthausen (1981) assigns a constant k to his utility function identifying kinks in the utility function at the target return whenever k > 1.3

2 Stephen Hawking's singularity work provided the inspiration of a force great enough to alter the concavity / convexity of the curve. 3 Cumova and Nawrocki (2007), p. 8.

These kinks are indeed the singularities and their noticeable effects on the underlying utility. The inverse holds true for its negative utility counterpart. One consistency with historical utility theories is, for inner benchmarks the sensitivity will be greatest. The method of computation for these functions will be partial moment calculations. The Lower Partial Moment (LPM) will handle all negative utility while the Upper Partial Moment (UPM) will handle all positive utility. Nawrocki and Cumova (2007) clearly illustrate the ability of partial moments to handle S-shaped and Reverse S-shaped utilities. The beauty of partial moments is that they allow for different targets to be calculated with variations in degrees; highly configurable to multiple constraints and do not require any distributional assumptions. The separate partial moments also allows for considerable asymmetry of the curve from the delineation of negative to positive utility. The formulas representing the n-degree LPM and q-degree UPM: 1 (, , ) = [ {0, , } ]
=

(1)

1 (, , ) = [ {0, , } ]
=

(2)

where Ri,t represents the returns of the investment i at time t, n is the degree of the LPM, q is the degree of the UPM, h is the target for computing below target returns, and l is the target for computing above target returns. Each investor will also have a unique preference for gains and losses. Exponents n and q will represent the investor's sensitivity to losses and gains respectively as identified in equations 1 and 2 above. These exponents will serve to augment any curve characteristics. The ratio of exponents n and q will determine an individuals relative risk seeking or risk aversion levels. Typically n : q will be > 1 to illustrate overall risk aversion and the nonlinear relationship 8

investors have towards gains and losses. Lopes (1999) notes, Allais (1952, 1979) demonstrated that linearity failed in qualitative tests comparing choices in which 'certainty' was an option to choices in which it was not. The function has several parts for both LPM and UPM and is highly conditional to the underlying level of utility versus the benchmarks. The prospect theory value function is also a conditional formula tied to the underlying value versus its reference point shown in equation 3: (|) = { ( ) ( ) > (3)

where > 0 is the loss-aversion parameter, RP is the reference point that separates losses from gains, and > 0 measures the curvature of the value function (Post, Van den Assem, Baltussen and Thaler, 2008). Meanwhile, our external benchmarks coincide directly with the various LPM and UPM levels of the utility and are not necessarily derived in an ubiquitous manner. Individuals are quite erratic in their rationale for selecting benchmark levels as evidenced by the reasons provided in historical utility experiments.4 Whether predetermined or path dependent,

quantitatively or qualitatively derived, a loss of X will generate an LPM(n,h,x) to the investor to be then used in the function deriving a utility value for said loss. The investor will also have a benchmark to which the loss is compared to. Typically a benchmark for an equity investment is the broader S&P 500 index. The downside measure of the investment, LPM(n,0,x) would then be compared to the LPM(n,0,y), or the downside measure of the S&P 500. In this example, Y = S&P 500 and the target for the LPM calculations would be 0, identifying the nominal downside measures for both. Another benchmark, Z can also be

introduced. Z often represents the risk free rate or 3 month T-Bill for equity investments. So

4 Lopes and Oden (1999). LS vs SS experiment, p. 304.

now you have LPM(n,0,x), the investment, LPM(n,0,y) the S&P 500, and LPM(n,0,z) the 3 month T-Bill.5 The same benchmarks can be used for UPM calculations, or if the individual wishes to compare their upside measurements to a different set of benchmarks the function can accommodate it. The target for all benchmarks does not have to be 0. For instance, the LPM's in the prior example can be computed with the nonstationary 3 month T-Bill as the target and the downside measurements compared from that point, instead of a stationary target. There are no limits to the number of benchmarks or constraints on target selection; this is left entirely up to the individual. Another common trait among historical utility functions is their desire to adhere to stochastic dominance orders. Lopes and Oden (1999) mentions this, An obvious candidate at the time was prospect theory (Kahneman & Tversky, 1979), but this model violated stochastic dominance, 'an assumption that many theorists [were] reluctant to give up' (Tversky & Kahneman, 1992, p. 299) Levy and Levy (2002), Wakker (2003), Post and Levy (2005), Baltussen, Post and van Vliet (2006), find most of the empirical evidence supports the Reverse S-shaped utility functions found in the MSD and MSDL dominance criteria shown in Figure 4. The Markowitz Stochastic Dominance most closely resembles each our autonomous utilities. While stochastic dominance is too constrictive for our purpose, the shape of the utility is most compelling. Our function dismisses the restraints, most notably of stationarity assumptions and non-equal treatment of above target returns, which hinders stochastic dominance from being a worthwhile application. Holthausen (1981) shows us that SSD and TSD do not include utility functions with > 1.6 The reason for this is SSD and TSD are derived from cumulative density functions that only consider below target probabilities (- to k). They therefore make no

5 LPM for risk free rate will be = 0, as there are no losses associated with it. 6 Levy and Levy (2000).

10

distinction between below target gains, above target losses, and below target losses. postulate that there are very different connotations for each of those distinct scenarios.

We

While some will undoubtedly plea for a non-parametric stochastic dominance due to the specification error of a parametric function over large intervals, we offer this analogy. Our parametric model offers a glimpse of the underlying utility in a method similar to that used by Seurat or Monet. The pointillism and impressionism methods will never offer a photograph quality sought after by the Realists, however, they offer a significantly more detailed view of the underlying image versus that of a Cubist. Stochastic dominance in its aim to encompass

everything distorts the true representation of the underlying like that of a Cubist.7

Utility

PSDL

PSD

Losses

Gains

Losses

Utility

Gains

Utility

MSDL

MSD

Utility

Losses

Gains

Losses

Gains

Figure 4. Example of non-concave utility functions that are consistent with the assumptions of Prospect Stochastic Dominance with Loss Aversion (PSDL), Prospect Stochastic Dominance (PSD), Markowitz Stochastic Dominance with Loss Aversion (MSDL), and Markowitz Stochastic Dominance (MSD). Source: Post and Levy (2005)

7 Appendix A will expand this argument.

11

We will present the function as a whole in Figures 5 and 6. The explanation of each descriptive conditional subset with normative examples will follow. From there we will explain all relevant utility paradoxes in the context of the multiple upper and lower partial moment utility framework. We refrain from the orthodox methodology of utility testing via classroom Our function contains a singularity, the Personal

experiments of hundreds of students.

Consumption Satiation point (PCS) whereby the underlying concavity of an individual's utility is transformed. Unfortunately, we do not have access to enough material wealth to offer subjects whereby we could extrapolate the findings of choices of uncertainty. These experiments

historically centered around de minimis sums of money, questioning the legitimacy of the extrapolation if the PCS is not effected. The typical experiment also is also identified within the UPM realm, there are no losses involved thus no threat to the individual's subsistence level. This raises the question -- what data then is relevant to an individual's utility function? Certainly their retirement portfolios would satisfy our requirements, however, observing an individual's investment actions at every observable point is not conceivable. We also cannot deaggregate individual utility information from security prices. The individual's statements would indeed offer a glimpse into the economic agent's choices involving uncertainty with substantial assets affecting the PCS, however, the list of individuals willing to divulge such information is limited. Fortunately, we do analyze some data available from the game show Deal or No Deal and extrapolate the work done by Post et al. within our utility framework. The findings do indeed support the notion of risk seeking with gains that prospect theory dismisses with its concavity of positive utility. To put it more bluntly, we explain the irrational behavior that confounds

historical utility theory while maintaining an adherence to the laws of diminishing marginal

12

utility (until the PCS). Economic agents are not always rational utility maximizers as witnessed by security market's participants. The other notable difference is the sum over histories

methodology versus the analysis of aggregated data. The very nature of a sum over histories enables a more detailed explanation of the residuals that dominate other parametric models. Our enhanced specification sows the seeds for reflexivity and other theories that deviate from the orthodoxy. We accomplish this with normative examples to generate a framework from which more descriptive testing can be considered and attempted to better understand the individual nature of decisions under uncertainty.

13

SINGLE BENCHMARK UPM / LPM UTILITY

0
Losses Gains

Utility

U(x)

0
Figure 5. Single Benchmark Utility Function.

f ( LPM (n,h,x) LPM (n,y,x) + U(0)) f ( LPM (n,h,y) + UPM (n,y,x) + U(0)) f ( LPM (n,h,y)) U(x) = f (UPM (q,l,a) LPM (q,a,x) + U(0)) f (UPM (q,l,x) + UPM (q,a,x) + U(0)) f (UPM (q,l,a))

LPM Conditional Values If LPM (n,h,x) LPM (n,h,y) > 0 If LPM (n,h,y) LPM (n,h,x) > 0 If LPM (n,h,x) = 0 UPM Conditional Values If UPM (q,l,a) UPM (q,l,x) > 0 If UPM (q,l,x) UPM (q,l,a) > 0 If UPM (q,l,x) = 0

UPM ( ) = Upper partial moment (degree, target, benchmark) LPM ( ) = Lower partial moment (degree, target, benchmark) n = Investor's loss aversion level q = Investor's gain seeking appetite h = Target for computing LPM l = Target for computing UPM x = Investment y = Benchmark Y a = Benchmark A

14

MULTIPLE BENCHMARK UPM / LPM UTILITY

Utility U(x)

Losses

Gains

0
Figure 6. Multiple Benchmark Utility Function
f ( LPM (n,h,x) LPM (n,y,x) + U(0)) f ( LPM (n,h,x) LPM (n,z,x) + U(0)) f ( LPM (n,h,y) + UPM (n,y,x) + U(0)) f ( LPM (n,h,y) + UPM (n,z,x) + U(0)) f ( LPM (n,h,y) + UPM (n,y,x) + U(0)) f ( LPM (n,h,y) + UPM (n,z,x) + U(0)) U(x) = f (UPM (q,l,b) LPM (q,b,x) + U(0)) f (UPM (q,l,a) LPM (q,a,x) + U(0)) f (UPM (q,l,a) LPM (q,a,x) + U(0)) f (UPM (q,l,b) LPM (q,b,x) + U(0)) f (UPM (q,l,x) + UPM (q,a,x) + U(0)) f (UPM (q,l,x) + UPM (q,b,x) + U(0)) UPM Conditional Values If UPM (q,l,a) UPM (q,l,b) UPM (q,l,x) > 0 If UPM (q,l,b) UPM (q,l,a) UPM (q,l,x) > 0 If UPM (q,l,a) UPM (q,l,x) UPM (q,l,b) > 0 If UPM (q,l,b) UPM (q,l,x) UPM (q,l,a) > 0 If UPM (q,l,x) UPM (q,l,a) UPM (q,l,b) > 0 If UPM (q,l,x) UPM (q,l,b) UPM (q,l,a) > 0 LPM Conditional Values If LPM (n,h,x) LPM (n,h,y) LPM (n,h,z) > 0 If LPM (n,h,x) LPM (n,h,z) LPM (n,h,y) > 0 If LPM (n,h,y) LPM (n,h,x) LPM (n,h,z) > 0 If LPM (n,h,z) LPM (n,h,x) LPM (n,h,y) > 0 If LPM (n,h,z) LPM (n,h,y) LPM (n,h,x) > 0 If LPM (n,h,y) LPM (n,h,z) LPM (n,h,x) > 0

UPM ( ) = Upper partial moment of target (degree, target, benchmark) LPM ( ) = Lower partial moment of target (degree, target, benchmark) n = Investor's loss aversion level q = Investor's gain seeking appetite h = Target for computing LPM l = Target for computing UPM x = Investment y = Benchmark Y z = Benchmark Z a = Benchmark A b = Benchmark B

15

Section 1

Loss Aversion Below All Benchmarks

When an investment under performs all of the LPM benchmarks it is being compared to, the utility will decrease at an exponential rate consistent with the investor's loss aversion n, as this reflects an encroachment upon basic necessities. This outermost LPM represents Roy's subsistence level, identified as S by Lopes (1987). The more one loses at this point, the closer to 0 wealth the investor becomes with no margin for error. The LPM of the investment, LPM (n,h,x) , will increase as losses are extended. The marginal utility lost from under performance will also be exponentially factored at a rate consistent with the investor's loss aversion level, n from the original LPM calculation. This ensures the investor's loss aversion profile is uniformly quantified. The marginal utility subtracted also represents the opportunity cost investors

compare themselves to. In essence, the I should have... we all tell ourselves. Whether direct or marginal, a loss is a loss and the LPM's are given a negative sign to their positive value to illustrate the negative utility. The formula representing this scenario with a target of 0 for the ndegree LPM is:

f ( LPM (n,0,x) LPM (n,y,x) + U(0))

LPM Conditional Values If LPM (n,0,x) LPM (n,0,y) > 0 (4)

Single Benchmark

f ( LPM (n,0,x) LPM (n,y,x) + U(0)) f ( LPM (n,0,x) LPM (n,z,x) + U(0))

LPM Conditional Values If LPM (n,0,x) LPM (n,0,y) LPM (n,0,z) > 0 If LPM (n,0,x) LPM (n,0,z) LPM (n,0,y) > 0 (5) Multiple Benchmarks

LPM (n,0,y) is the lower partial moment associated with the investor's subsistence level S benchmark in equation 4 illustrated with a 0 target, whereby S = LPM (n,0,y). LPM (n,0,y) and LPM (n,0,z) are the lower partial moments of the investor's downside tolerances for multiple benchmarks shown in equation 5. Typically this is accomplished by some form of mental 16

accounting by the investor, creating independent utilities.8 Physical separation of accounts would be an extrapolation of this mental accounting method. Each account will have its own utility function and associated benchmark; however, investors can evaluate them in aggregate to their total wealth. Multiple singularities are the aggregation of such accounting. This section of the function refers to the LPM (n,h,x) LPM (n,h,y) or LPM (n,h,z). This is the area where losses represent the worst predicted outcome for the investor. Every increase in losses will exponentially encroach upon the investors ability to provide basic subsistence consistent with Roy's subsistence level S. It is therefore a concave section of the function. Figure 7 highlights this section of the function and an example will help clarify.

0
Losses Gains

Utility

U(x)

Lowest LPM

Figure 7. Concave negative utility below the subsistence level S for a single benchmark.

Lopes uses a subsistence farmer analogy in her 1987 paper, therefore we will continue with the fate of the farmer because it highlights utility in its purest form, survival. Suppose a farmer plants a portion of his crop that he would need to survive to a food crop. The total crop utility function U(x), would be bound by the acreage of both crops. Suppose there are 10 total
8 Shefrin and Statman (2000).

17

acres, and the farmer needs 6 acres dedicated to his food crop for survival through the winter. The remaining 4 acres would be planted for a cash crop. Since it is a cash crop, the exchange rate to the food crop is not linear. According to most practitioners, the farmer is doing the prudent thing by diversifying his risk across different crop types. 9 If the food crop fails to produce a single harvested meal, at least he could barter whatever gains are realized from the cash crop. The total loss of the food crop and the path dependent utility10 of the cash crop is the part of the function this section is analyzing. As the cash crop fails to produce, an increasing LPM (n,h,x), the farmer's ability to survive is exponentially challenged with each unharvested row of cash crop since it can be exchanged for a greater amount of food crop. Eventually the

farmer will have maximized their negative utility and harvested 0 acres, a total loss. This example highlights an important point -- even though the utility is concave for losses it is bound by the individual's total wealth. The total amount of acreage for both crops is the binding variable in this example. There is a noticeable difference in utils from 0 acre to 1 acres and slightly less for the second acre of cash crop harvested. The utils will increase at a diminishing rate until he is able to sustain his existence, LPM (n,h,y). A convex loss function would have the difference in utils of 0 to 1 acre harvested as negligible below the benchmark. Good luck explaining that to the farmer. For multiple benchmarks, the effects and the equation is identical for whichever benchmark has the largest LPM, LPM (n,h,y) or LPM (n,h,z) since either would coincide with the investor's subsistence level S as highlighted in Figure 8 below.

9 Appendix A will further the discussion of dynamic covariances and the inverse effects of diversification 10 Post, Van den Assem, Baltussen, and Thaler (2008).

18

Utility

U(x)

0
Losses Gains

Figure 8. Concave negative utility below subsistence level S for multiple benchmarks.

Lowest LPM

19

Section 2

Gain Seeking in between the LPM Benchmarks for Multiple Benchmarks

If an investment performs better than one lower benchmark, the utility will increase at a rate of the marginal utility gained from losing less. However, one does not receive a marginal utility increase reflective of their gain seeking level; rather, the marginal utility is consistent with their loss aversion n since we are still in the domain of negative utility. It therefore mimics the effects of traditional risk seeking with losses notions while utilizing all negative utility components. Lopes (1999), notes Experimental studies using managers as subjects have also confirmed the tendency toward risk-taking for losses, at least when ruin is not an issue (Laughhunn, Payne, & Crum, 1980 and; Payne, Laughhunn, & Crum, 1981) This quote refers to utility above the outermost LPM, or the subsistence level S of the investor we identified with Roy in Section 1. It is further backed up by Post et al. (2008) as they note in their Deal or No Deal analysis, Risk aversion seems to decrease after earlier expectations have been shattered by opening high-value briefcases, consistent with a 'break-even effect' illustrating the desire to get what they refer to in golf as a Mulligan, pre-opportunity cost. However, this increased risk tolerance can easily lead the individual to the below target utility of the prior section. The LPM of the investment, LPM (n,h,x) will decrease as the investment loses less. The marginal utility of loss aversion added to the negative utility of the benchmark will represent the it could have been worse scenario we all contemplate. When multiple benchmarks are used, this section will be in a lower utility subset than one bounded by a smaller LPM value. The utility shift realized from traveling through the

singularity reflects the passing off of dominance to the next LPM benchmark. As the utility is not below the outermost LPM, the shape of the function will be convex for losses.

20

Our farmer gets a break as a more fitting example for this section would be an investor with a short dated portfolio and a long dated portfolio for retirement, outside of their employment. Traditional investment portfolios would be independent from the investor's other income generating activities such as employment. Fund managers with significant portions of their own wealth in the fund they manage are a different utility study. The formula representing this section is:

f ( LPM (n,h,y) + UPM (n,y,x) + U(0)) f ( LPM (n,h,y) + UPM (n,z,x) + U(0))

LPM Conditional Values If LPM (n,h,y) LPM (n,h,x) LPM (n,h,z) > 0 If LPM (n,h,z) LPM (n,h,x) LPM (n,h,y) > 0 (6) Multiple Benchmarks

The investor's LPM (n,h,y) would represent the downside tolerance associated with the short dated portfolio, while LPM (n,h,z) represents the lower benchmark for the long dated retirement portfolio. The wider LPM (n,h,z) for the retirement account signifies the function of time and frequency on investor loss tolerances. This is the outermost benchmark for the investor and if the singularity is eclipsed through increased losses, the scenario from Section 1 plays out. The important distinction for this section is the lower utility subset once the short dated portfolio under performs its LPM (n,h,y). Highlighting the individuals increased sensitivity nearest the benchmark that historical utility has identified earlier. The function is now lower bound by the LPM (n,h,z) and if the losses with the short dated portfolio eclipse its loss benchmark, the utility driver will be the performance of the long dated portfolio for the investor's aggregate utility function. The overall losses are not encroaching upon the investor's basic necessities at this point and will be convex into the LPM (n,h,z) as the short dated portfolio loses more and more. The difference in utils for the goal associated with the short dated portfolio is negligible as it approaches its outermost LPM, or investor's subsistence level S for that particular 21

portfolio whereby an investor deems the losses to that point not to threaten their subsistence. It is possible a short dated portfolios losses are so great that it forces the investor's aggregate utility below their subsistence level, and then into the concave loss realm that Section 1 covered. Figure 9 graphically depicts the shift to a lower utility subset, as LPM (n,h,x) increases. This example isolates the effect of the performance of the short dated portfolio. However, investors can and do utilize certainty equivalents from other portfolios to offset losses thereby desegregating the independent mental accounts when faced with adverse situations from one of the accounts. The CDO losses on the banks' balance sheets and the Fed's response is a clear illustration of this,11 as is the reluctance of Japanese banks to sell the non-performing loan portfolios for over a decade. In essence, investors rob Peter to pay Paul on individual, corporate and sovereign levels and desegregate allegedly independent accounts.

Utility

U(x)

0
Losses Gains

Lowest 0 LPM Benchmark

Figure 9. The shift lower from one utility subset to another for multiple singularities, convex utility lower bound by S.

11 Appendix A expands this reference.

22

Section 3

Gain Seeking Above the Lowest LPM Benchmark

Again, if an investment performs better than the lowest LPM benchmark, the utility will increase at a rate of the marginal utility gained from losing less than associated tolerances are accounting for or others are experiencing. However, one does not receive a marginal utility increase reflective of their gain seeking level; rather, the marginal utility is consistent with their loss aversion n, since we are still in the domain of negative utility. The LPM of the investment, LPM (n,h,x) will decrease as the investment loses less. The marginal utility of loss aversion added to the negative utility of the benchmark will represent the it could have been worse scenario we all contemplate. The formula representing this section is:

f ( LPM (n,h,y) + UPM (n,y,x) + U(0))

LPM Conditional Values If LPM (n,h,y) LPM (n,h,x) > 0 (7)

Single Benchmark

f ( LPM (n,h,y) + UPM (n,y,x) + U(0)) f ( LPM (n,h,y) + UPM (n,z,x) + U(0))

LPM Conditional Values If LPM (n,h,z) LPM (n,h,y) LPM (n,h,x) > 0 If LPM (n,h,y) LPM (n,h,z) LPM (n,h,x) > 0 (8) Multiple Benchmarks

Again, let's get back to the unfortunate farmer. Isolating the food crop he planted, as harvest rates fall the farmer is faced with the law of diminishing marginal utility. The difference in utils realized from 2 to 3 acres of food crop harvested when the farmer had allotted 6 for subsistence is negligible as it simply is not enough to provide through the season. At this point the driver of his utility will be his cash crop, but for simplicity we have left the simultaneous effects of the cash crop out. Ordinarily the farmer will consider the aggregate utility from both crops if the food crop falters. This section is upper bound by 0. It is also convex and highlights the increasing utility gained from losing less when approaching a breakeven level. This section is also consistent with 23

prospect theory increased sensitivity near its reference point (Kahneman and, Tversky, 1979) and convexity of losses. Figures 10 and 11 illustrate this section for both single and multiple benchmark scenarios.
U(x)

Utility

U(x)

0
Losses Gains

0
Losses Gains

Lowest LPM

Lowest 0 LPM Benchmark

Figure 10. Single benchmark convex negative utility upper bound by 0, lower bound by S.

Figure 11. Multiple benchmark convex negative utility upper bound by 0, lower bound by lowest LPM benchmark.

Utility

24

Section 4

Loss Aversion Below the Lowest UPM Benchmark

If an investment generates a positive return, then a positive utility is recognized. However, the relationship between gains and utility is far from linear. Investors have been utilizing upper benchmarks to calculate excess returns such as the risk free rate since the 1960s. An overwhelming proportion of research over the last 40 years has been dominated by the investigation of downside risk quantification and the under-performance of these benchmarks.12 The risk free rate, S&P 500, minimum acceptable return or any other conceivable benchmark, with no stationarity constraints13 as in a stochastic dominance ranking, can be accommodated by this function. When an investment under performs the first of its positive benchmarks, the utility realized will increase with the diminishing effects of the marginal utility from the first benchmark, the should have marginal utility. The marginal utility subtracted will decrease at a rate consistent with the investor's gain seeking level q, since the utility is still positive. It mimics the risk averse with gains sentiment prevalent in all experimental utility situations (mock lotteries) from the historical references made earlier by utilizing all positive utility terms. Again, Post et al. (2008) notes this effect in their Deal or No Deal analysis, Risk aversion seems to decrease after earlier expectations have been shattered by opening high-value briefcases, consistent with a 'break-even effect' upper bound by the lowest UPM benchmark. The ill effects of this behavior can be noted in the concavity below the UPM benchmark. The influence of the certainty equivalent when an investor's wealth is under their personal consumption satiation (PCS) benchmark can be noticeable and highly variable. The propensity

12 Sharpe Ratio and the R/SV ratio. 13 Saunders, Ward and Woodward (1980).

25

to see through a lottery increases with overall wealth creating a house money effect 14

and

highlighting a decreased UPM, narrowing the range for which deals will be taken in lieu of the grand prize regardless of frequency. Increasing the wealth level would imply near risk

neutrality for even larger gambles. Post et al. (2008). Historical classroom controlled utility experiments share something with this section of the function. It is lower bound by 0. In most researchers utility experiments and observations, the subjects do not leave the study with any difference in actual wealth from when they entered. This is just not consistent with real life investment decisions and the simulated replication done historically does not seem to provide an adequate bridge between the two. Deal or No Deal made a promising step forward; however, it is clearly solely an exercise in a contestant's positive utility. The formula for this section is: f (UPM (q,l,a) LPM (q,a,x) + U(0)) UPM Conditional Values If UPM (q,l,a) UPM (q,l,x) > 0 (9)

Single Benchmark

f (UPM (q,l,b) LPM (q,b,x) + U(0)) f (UPM (q,l,a) LPM (q,a,x) + U(0))

UPM Conditional Values If UPM (q,l,a) UPM (q,l,b) UPM (q,l,x) > 0 If UPM (q,l,b) UPM (q,l,a) UPM (q,l,x) > 0 (10) Multiple Benchmarks

Let's check in on our farmer. It seems as their luck has turned. The food crop is producing towards a rate of personal consumption satiation. The harvest is following the law of diminishing marginal utility in so much as the farmer can only eat so much. This section of the function is concave and would highlight the negligible difference in utils from harvesting 5 or 6 acres of food crop. This section of both single and multiple benchmarks functions is consistent with the concavity of gains associated with prospect theory.

14 Appendix A expands on this idea.

26

Figures 12 and 13 below highlight these sections of both equations. Envision this as the section as the starting point for all game shows and historical utility experiments as this is the commencement of our UPM analysis.

Utility

0
Losses Gains

0
Losses Gains

Lowes PCS UPM Benchmark

Utility

U(x)

U(x)

Lowest PCS UPM Benchmark

Figure 12. Single benchmark concave positive utility lower bound by 0, upper bound by the investor's PCS.

Figure 13. Multiple benchmark concave positive utility lower bound by 0, upper bound by lowest UPM benchmark.

27

Section 5

Loss Aversion in between the UPM Benchmarks for Multiple Benchmarks

When an investment passes its first upper benchmark, the investor can breathe a sigh of relief. This sigh is captured through a shift in dominant benchmarks once that hurdle is cleared. Again, this highlights the increased sensitivity near the benchmark which historical utility theory has taught us. The investment however, is still under performing its next benchmark, and the investor's utility is immediately derived from this new utility subset in regards to their overall wealth. The principles will be similar to Section 4 whereby the investment is under performing a benchmark; however it will be at a higher level of utility. The concave loss aversion with gains scenario still dominates as the investor should have contemplates, but considers it could have been worse with the lower UPM, hence the higher starting point for the marginal should have utility to be subtracted from the higher benchmark utility. For our multiple portfolio investor, this section represents the out performance of the short dated portfolio UPM (q,l,a). Again for simplicity reasons we will ignore the simultaneous performance of the long dated retirement portfolio. The investor's utility is now upper bound by the outermost UPM (q,l,b). The certainty equivalent will also reign as the investor's overall wealth is still under their personal consumption satiation, UPM (q,l,b), which serves as the upper boundary for this section of the function. All historically referenced utility experiments are upper bound by the participant's personal consumption satiation. None of them offer a chance to catapult the participant above that level of wealth whereby utility decisions would be materially altered. The robbing Peter to pay Paul scenario (certainty equivalence) would be relevant dependent on the relative performance of the two portfolios. Figure 14 graphically illustrates this. Instead of the utility turning convex for gains, we note the binding effect of the outermost

28

UPM benchmark. The concavity of gains in this section is also consistent with prospect theory gains as in Section 4. This formula is represented by:

f (UPM (q,l,a) LPM (q,a,x) + U(0)) f (UPM (q,l,b) LPM (q,b,x) + U(0))

PM Conditional Values If UPM (q,l,a) UPM (q,l,x) UPM (q,l,b) > 0 If UPM (q,l,b) UPM (q,l,x) UPM (q,l,a) > 0 (11) Multiple Benchmarks

0
Losses Gains

Utility

U(x)

Lowest PCS UPM Benchmark

Figure 14. The shift higher from one utility subset to another for multiple singularities, lower bound by the lowest UPM benchmark and upper bound by the investor's PCS.

29

Section 6

Gain Seeking above all UPM Benchmarks

The inverse of Section 1 applies here. When all upper benchmarks are cleared by the investor, their utility will be that of the investment plus the marginal utility of beating the highest UPM benchmark consistent with their gain seeking level. Post et al. (2008) observe this very behavior, Similarly, risk aversion seems to decrease after earlier expectations have been surpassed by opening low-value briefcases, consistent with a 'house-money effect'. The

singularity of the outermost UPM has transformed the curve from concave to convex. This is where it gets interesting. An overwhelming majority of us would arrest our accumulation of monetary wealth once our personal consumption satiation level has been reached. Some of us have not ceased. In the cessation process, the investor is deemed to be a utility maker with direct outcome upon their levels. In certain instances, the investor may be a utility taker, i.e., a lottery payoff. If given the choice between a $1 million certain payoff or the grand prize of say $10 million, the majority, as evidenced back to Friedman and Savage would be utility makers and would take the certain payoff, thereby illustrating how the certainty equivalent reigns supreme when an investor's wealth level is below their personal consumption satiation level, regardless of the prevalence of a discount to expected value. If the individual is fortunate enough to be presented with the opportunity to partake in this situation again, the certainty equivalent is not as certain. This section also helps define the actual components of utility. For some, this section of the function represents the ability to provide for others in a method they see fit and is no longer guided by the utility of money. Most philanthropy abides by the guidelines of the benefactor, giving the benefactor personal non tangible utility. The law of diminishing marginal utility is replaced by economies of scale when we are discussing personal utility on a non-tangible scale. 30

To the first point, the evidence we reviewed is quite supportive: Happier people give more and giving makes people happier, such that happiness and giving may operate in a positive feedback loop (with happier people giving more, getting happier, and giving even more) (Anik, Aknin, Norton and Dunn, 2009). Let's take an exaggerated example to give clarity. From Bernoulli through path dependent utility, all have bound Y axes, meaning the difference in wealth between $1 billion and $100 billion is barely noticeable, a fraction of a util. We disagree. If an investor's utility was derived also by how many people they could help in a manner they see fit, then there is an enormous difference in utils from $1 billion to $100 billion in total wealth. We do share one common belief; the function will ultimately be bound on the X axis by the total amount of monetary resources available. The farmers X axis is bound by the 10 acres of land, thus negating the St. Petersburg paradox. The formula for this section is: UPM Conditional Values If UPM (q,l,x) UPM (q,l,a) > 0 (12)

f (UPM (q,l,x) + UPM (q,a,x) + U(0))

Single Benchmark

f (UPM (q,l,x) + UPM (q,a,x) + U(0)) f (UPM (q,l,x) + UPM (q,b,x) + U(0))

UPM Conditional Values If UPM (q,l,x) UPM (q,l,a) UPM (q,l,b) > 0 If UPM (q,l,x) UPM (q,l,b) UPM (q,l,a) > 0 (13) Multiple Benchmarks

Let's see how our farmer is doing. It has been a bumper crop for his whole amount of land. They now have all of the food they can eat for the foreseeable future and have acres of harvested cash crop. All other utility functions would classify the additional cash crop as marginally useless. This would be true if we were only concerned about the farmer's appetite, as it is clear they cannot eat a morsel more. So the cash crop harvest in the context of the food crop harvest has no discernible utility? Suppose the farmer were to sell the cash crop for additional storage, extending his certainty of survival with food crops. Or say the farmer was going to 31

purchase an adjacent parcel of land to increase the acreage of his farm. These two examples represent negligible utility? We didn't think so either. These examples are of non-tangible utility to the farmer in the context of their bumper food crop. Also, the farmer was a utility taker; they clearly would not destroy the additional acreage of the cash crop in order to cease acquiring utility beyond their personal consumption satiation point. Figures 15 and 16 below highlight this important curve characteristic.
U(x)

Utility

0
Losses Gains

0
Losses Gains

Utility

U(x)

Lowest PCS UPM Benchmark

Lowest PCS UPM Benchmark

Figure 15. Single benchmark convex positive utility above the investor's personal consumption satiation level.

Figure 16. Multiple benchmark convex positive utility above the investor's personal consumption satiation level.

32

SUM OVER HISTORIES The prevalence of nonstationarity in financial markets is often the cause of a quantitative model's demise. This dynamic, nonlinear, chaotic force can be observed on all scales and fractals of both time series and price data with the root of this force being the random actions of the individuals generating this data. We offer a glimpse into this conundrum via the series of

adjustments to the benchmarks an individual will make over the period of their investment. Post et al. (2008) note this, The specification of the subjective reference point (or the underlying set of expectations) and how it varies during the game is crucial for our analysis, as it determines whether outcomes enter as gain or loss in the value function and with what magnitude. The non-transitive nature of a utility observation at time t means that even if Xt = Xt-1 they can have 2 wildly different interpretations due to the shift in either a UPM or LPM benchmark. Figure 17 illustrates the difference in 2 utility measurements that have equal value yet Xt-1 lies on the convexity for above benchmark (the derivation of that benchmark is some function of the prior period's utility f (Xt-2)) utility while the other, Xt now falls on the lower concavity of below benchmark (f (Xt-1)) utility after the individual altered their UPM benchmark from the prior outcome. Using our farmers 2 crop example, at harvest there are 35 possible utility outcomes. Assuming he maintains the same diversification of 6 food crop acres and 4 cash crop acres for the next harvest; that observed harvest will also have 35 possible utility outcomes. Thus the 2 period, 2 crop path has 1,225 utility combinations it could have taken to its next observation. This is a fairly easy analysis due to the infrequent periods of observation (harvests) and the low number of securities (crops). Also, the crops represent discrete probability distributions. If we extend the number of periods whereby an individual observes their portfolio of multiple 33

securities, the decision to buy, sell or hold based on that observation represents another harvest with associated risk profiles. For continuous probability distributions, there are an infinite number of outcomes based on the investors frequency of observation and number of securities, leading to an infinite number of utilities. It is for this reason we feel the sum over histories concept best explains single-period utility observations extended to multiple-period utility analysis.
U(x)t-1
Utility

U(x)t
Gains

Figure 17. Multiple interpretations for the same utility value illustrating the sum over histories nature of non stationary benchmarks.

Xt-1 = Xt

34

CONCLUSIONS

It is clear that the notion of marginal utility plays a very important part of investor's utility function and ultimately their decision making process. However, no two investors are alike and a universal utility function must be able to address all configurable differences between investors. It is also evident that utility comes in two forms, positive and negative. Each utility has their own function with their own parameters defining it. It is also possible for either to emulate the other with investor's attitudes of gain seeking and loss aversion. When concluding and debating prospect theory versus expected utility theory Post et al. (2008) note, However, a (nonstandard) utility function that has risk seeking segments and depends on prior outcomes could achieve a better fit. Such exotic specifications blur the boundary between the two theories, and we therefore do not reject or accept one of the two. If you noticed, the word risk has been deliberately taken out of its traditional context and not applied to where one would normally see it. The reason for this is straightforward, we need to better define the word before carelessly bandying it about and portraying false hopes for investors to rely upon. Risk is not solely a downside measure, the entire distribution, including gains, needs to be analyzed as a whole unit. Lopes and Oden (1999, p. 21) Few, however, have explored the possibility of modeling risk as the raw probability of not achieving an aspiration level. We hope this notion furthers research into redefining risk by illustrating the autonomous and equally important functions of both positive and negative utility, as well as the reexamination of previous utility work within the provided framework.

35

APPENDIX A INSURANCE NOT SOLELY AS WEALTH RETENTION Part of the historical debate on utility theory has centered around the investor's propensity to purchase both insurance and a lottery ticket. Recent examples may illustrate why insurance is not solely a means to wealth retention, but rather an asymmetrical negative event payoff or an inverse lottery. Traditional insurance such as life, auto, home serves a purpose of wealth

retention or wealth addition if the policy is the life example. Not to mention that insurance is mandated by most debt covenants such as mortgages, auto leases, and even state law. Insurance fraud, whereby individuals create an insured event; costs the insurance industry billions a year.15 This action highlights some individuals' desire to ensure payoff of an inverse lottery. Given a choice, it would be interesting to witness how many individuals would choose to self-insure thereby raising the question: Perhaps economic agents do not wish to smooth consumption over time? Warren Buffett in his 1986 letter to shareholders answers this very question, Charlie and I have always preferred a lumpy 15 % return to a smooth 12 % return. Ironic coming from his position as a purveyor of such policies intended to smooth consumption for his customers. What if you were able to purchase insurance on my insured interest? You would pay some premium and then receive a lump sum if the insured event occurs. While this is not common or even legal with traditional insurance policies, over the last decade it has become the norm on financial events known as defaults. The credit default swap was initially marketed as insurance for companies not able to meet their debt obligations. This makes sense for the bank holding the debt obligation to directly insure its exposure. But other banks started buying the insurance and started a speculative craze resulting in one of the largest markets in the world in a relatively short amount of time. On top of that, while deemed insurance fraud in the individual
15 http://www.insurancefraud.org/

36

example, banks and hedge funds participated in ensuring a covenant default (such as shorting the equity of the insured below covenant levels) in order to collect the default insurance. Morgan Stanley's and another unnamed bank's actions in May of 2009 illustrate this very behavior, when MS and the unnamed bank, acting as a creditor to BTA Bank of Kazakhstan, demanded the repayment of $550 million worth of notes instead of working with their borrower for a possible restructuring. But last week Morgan Stanley and another bank suddenly demanded repayment. BTA was unable to comply, and thus tipped into partial default. That sparked fury among some other creditors, and shocked some Kazakhs, who wondered why Morgan Stanley would have taken an action that seemed likely to create losses. One clue to the US banks motives, though, can be seen on the official website of the International Swaps and Derivatives Association. One page reveals that just after calling in the loan, Morgan Stanley also asked ISDA to start formal proceedings to settle credit default swaps contracts written on BTA.... ...As a result speculation is rife that Morgan might have deliberately provoked the default of BTA to profit on its CDS, since a default makes the US bank a net winner, not a loser as logic might suggest.16

Another article puts it more bluntly.... When you buy protection against an event that you have a hand in causing, you are buying fire insurance on someone else's house and then committing arson.17

The CDS example also highlights, due to the fact that it's unregulated and human behavior is allowed to flourish, that knowledge and ability to spot asymmetrical payoffs through whatever financial engineering is a part of the investor's risk tolerance function. While a portion of insurance is indeed wealth retention, part is also an inverse lottery and therefore, it is not puzzling as to why investors purchase both insurance and lottery tickets. Another issue with investors' insurance practices is diversification. Experts have taught
16 http://www.ft.com/cms/s/0/fa0428ee-35a7-11de-a997-00144feabdc0.html?nclick_check=1 17 http://www.nytimes.com/2009/12/24/business/24trading.html?_r=2&scp=1&sq=debt&st=cse

37

over the decades that diversification is the preferred means of insuring a portfolio. This is simply not the case. In times of crisis, correlations between securities tend towards 1. This throwing the baby out with the bath water situation tends to augment losses the investor tried to protect themselves from as there is no offsetting performance from sections of the portfolio. The only true means of insuring a security is through a married put strategy whereby a put option is purchased simultaneously with the underlying security, yet the prevalence of this pure insurance is muted. Li's copula, a formula widely used in analysis to construct CDOs failed due to its ignorance of these dynamic correlations in times of crisis and an underlying assumption of a Gaussian distribution for those correlations.18

CERTAINTY EQUIVALENT The power and pervasiveness of a certainty equivalent dominates most investor landscapes, including sovereign states. The Federal Reserve in response to the latest financial crisis has provided a certainty equivalent for a few market participants who have diversified portfolios which include sour CDO portfolios, among other poorly performing assets. Access to the Fed window to discount highly rated debt obligations for an above market rate allows the investors to free up capital in order to service those portfolios without selling them. In effect these participants are robbing Peter to pay Paul, via the TALF or Term Asset-Backed Securities Loan Facility. The TALF is designed to increase credit availability and support economic activity by facilitating renewed issuance of consumer and business ABS at more normal interest rate spreads....Under the TALF, the New York Fed will provide non-recourse funding to any eligible borrower owning eligible collateral. (http://www.newyorkfed.org/markets/talf_faq.html#4 ).

18 http://www.wired.com/techbiz/it/magazine/17-03/wp_quant?currentPage=all

38

This and other Fed liquidity measures do expire, at which point we will see whether the time purchased was worth it. Quantifying this certainty equivalent has been done in recent work. Post et al. (2008) have accomplished this in their Deal or No Deal analysis. They have isolated within the UPM utility, the certainty effect via the discount to expected value of the accepted bank offer. As the amount of the monetary prize increases, interestingly the discount to expected value also increases. Compared to the German and US contestants, the Dutch contestants on average accept lower percentage bank offers (76.3 percent versus 91.8 and 91.4 percent) and play roughly three fewer game rounds (5.2 versus 8.2 and 7.7 rounds). These differences may reflect unobserved differences in risk aversion due to differences in wealth, culture or contestant selection procedure. What Post et al. (2008) attempt to note in their observations is a certainty coefficient. ...we have also computed the implied certainty equivalent as a fraction of the expected value, or certainty coefficient (CC)...These values help to interpret the coefficient estimates by illustrating the shape of the utility function.19 The correlation of greater monetary amounts relative to their mean income shows the increased propensity to deal, or succumb to the certainty equivalent, but not to the extent of their model's certainty coefficient. This noted gaping difference illustrates the nonstationary risk seeking parameters of winners and losers our model allows for versus the optimized parameters, ...selected to maximize the overall loglikelihood.20 The stationary optimized parameters derived serve an explanatory role on the entire data set. However, the ability of Post et al.'s model to serve a predictive purpose on a nonstationary process is challenged by the nature of its explanatory construction. Table 1 highlights this relationship.

19 Post et al. (2008). 20 Post et al. (2008).

39

Table 1. Deal or No Deal Income to Deal ratios

Country Germany U.S. Netherlands

Mean Deal Amount 20,602.56 $122,544.58 227,264.90

Multiple of per capita income21 Percentage of Offer Accepted 0.69 2.53 6.49 91.8 91.4 76.3

Bank

Perhaps it is solely due to the larger prize pool in the Dutch version, or perhaps it is due to the frequency of participation in this one chance, whereby the contestant does not wish to come away empty handed, thus increasing the certainty equivalent. Samuelson (1963) notes similar behavioral patterns dictated by frequency via a lunchtime coin toss wager. Of course the missing data points in the contestant profiles of income and wealth would go a long way in expanding this, and we would hope should warrant further research into this noticed correlation of a larger single payoff versus a larger discount to expected value, compared to an increased frequency of similar situations. Unfortunately, game show producers realize this too and

generally one is only allowed a single visit thereby limiting our data.
In mathematics you dont understand things. You just get used to them. Johann von Neumann

They found that people would have to have a coefficient of relative risk aversion over 30 to explain the historical pattern of returns....Also, Mankiw and Zeldes [1991] provide the following useful calculation. Suppose that an individual is offered a gamble with a 50 percent chance of consumption of $100,000 and a 50 percent chance of consumption of $50,000. A person with a coefficient of relative risk aversion of 30 would be indifferent between this gamble and a certain consumption of $51,209. Few people can be this afraid of risk22

21 IMF 2008 nominal per capita income and an exchange rate of $1.5 to 1 is used to generate the multiple http://en.wikipedia.org/wiki/List_of_countries_by_GDP_(nominal)_per_capita 22 Thaler and Benzarti (1995).

40

This discount to expected value within a UPM utility of 68.28% ($51,209 certain consumption divided by the expected value $75,000) Mankiw and Zeldes identify is in the realm of the 76.3% bank offer accepted in the Dutch version of Deal or No Deal, and clearly not off by an order of magnitude. Viewed differently, the 4.8% certain consumption level Mankiw and Zeldes identify ($1,209 premium to worst case divided by the expected value difference from worst case of $50,000) is also consistent with the percentages provided by Post et al. (2008); where their path dependent model implied certainty coefficient for the neutral group of Dutch contestants implies indifference at 3.2% of expected value for large prizes.23 Are the Dutch that afraid of risk or is risk not being defined correctly? The Dutch also went through a path dependent dynamic decision process to arrive at their discount versus a fictional one shot deal. The coefficient of relative risk aversion over 30 that Mankiw and Zeldes tried to highlight blatantly ignores the certainty equivalent individuals clearly exhibit by defining this coefficient as solely loss aversion.24 Also, assume a more realistic scenario observed with equity investments whereby portfolios often represent multiple times an individual's annual income, there were a LPM represented so that the bet equally likely to lose $150,000 or pay $300,000 yielding the same expected value of $75,000. Does the propensity to accept a certain payoff of $51,209

representing a more normal loss aversion coefficient ex certainty equivalence seem that peculiar? We didn't think so either, thereby explaining the premiums in equity returns over the last century versus the risk free, certain, alternative. These premiums are therefore not a puzzle when the certainty equivalent is factored simultaneously with historical loss aversion notions to properly quantify a relative risk aversion coefficient.

23 Post et al. (2008) p. 47. 24 Sections 4 and 5 of this paper identify the loss aversion with gains, since there are no losses or LPM in the game show or Mankiw's example

41

TANGIBLE VS. NON TANGIBLE UTILITY Tangible utility affects an individual on a level comparable to the magnitude of the certainty equivalent. With all trading, the situation will undoubtedly arise whereby the trader does not know when to call it quits. The number on the screen under the P&L heading will not compute to actual dollars; as if the trader were playing a video game. These very real and instantly deposited profits could not and often do not represent tangible utility other than prolonging the amount of time and cushion they have to trade with. When one is in a casino, the house-effect is physically felt with the chips representing currency posing a somewhat different effect than profits realized on a computer screen. Financial asset statements as well as hard currency reserves are one step removed from non-tangible utility via their physical existence. However, to fully convert them into consumable materials would not be a practical maneuver. In order to alter a trader's risk profile, if their share of the profits realized were placed in cash on the desk next to them, one would notice how soon they stopped trading for the day as soon as you removed one $100 bill from the stack as a result from a bad trade. This example though not intended as an experiment in personal utility, rather a method of securing profits, highlights the difference between tangible and non-tangible utility. certainty equivalence when utility is transformed to a tangible form. It also reinforces the

SUM OVER HISTORIES EXAMPLES We have plotted the examples provided by Post et al. (2008)25 illustrating the sum over histories nature of their path dependent averages. Frank the loser and Susanne the winner both exhibited risk seeking tendencies. Figures 18 and 19 show the sequential averages and
25 Tables 3 and 4 p. 44-45.

42

Figure 20 then ranks the averages and compares both to a universal reference point, the starting average of all unopened cases. From this shared reference point we can clearly see the concavity for a series of below target results versus the convexity for a series of above target results. The examples and graphs below would be better served with more data points and we hope would further research into this specific topic as it is beyond the scope of this paper.

400000

160000

Average of Remaining Cases

350000 300000 250000 200000 150000 100000 50000 0

Average of Remaining Cases

Frank's New Average

140000 120000 100000 80000 60000 40000 20000 0

Susanne's New Av erage

11 10

10 11

Round
Figure 18. Frank's sequential returns.

Round
Figure 19. Susanne's sequential returns.

2500000

Average of Remaining Cases

2000000 Frank's New Average Susanne's New Average

Initial Reference Point

1500000

1000000

Figure 20. Combined ranked averages with shared reference point, illustrating concavity below and convexity above initial reference point for increased risk seeking behavior.

500000

Round 43

SPECIFICATION ERROR Stochastic dominance (SD), through its cumulative density function (CDF) comparisons encompasses all notions of utility within it and does not discern between them. It is also one continuous function versus the two autonomous functions we postulate. We have some questions as to the practicality of this single function non-parametric method. In the sum over histories example of Frank and Susanne above, let's examine how SD would evaluate the two CDF's from these managers. Neither demonstrates first degree (FSD) since in Susanne's average is less than Frank's after round 1. Susanne does display second degree (SSD) and third degree (TSD) dominance over Frank. How does SD alert the investor that both of these managers exhibited risk seeking path dependent tendencies? The general preferences SD allow for investors saying we prefer more to less for FSD. We allow for this preference in our model by permitting any degree of risk aversion / risk seeking via the ratio n : q. If an investor is risk averse and they prefer more to less, then SSD will suffice according to SD. We allow for risk aversion characteristics to be quantified by implementing n > q in our model. TSD is a decreasing risk aversion with respect to wealth. We also acknowledge this by a nonstationary UPM benchmark, whereby the singularity can be altered to reflect an increased propensity for risk seeking with gains. A major difference is that we account for these heterogeneous preferences at each observed interval via the altering of the steepness of the concavity / convexity through the n, q parameters coupled with the asymmetry of benchmarks; all plotted at time t. Time t + 1 will offer a different curve via our function, reflecting the dynamic heterogeneous preferences investors exhibit. SD merely sums all of these observations in its CDF's, blurring all of these points and dismissing target variances from estimation errors over the multiple-period analysis. We sum these points to generate a sum over

44

histories, thus avoiding any non-transitivity violations, which SD cannot account for. Expanding on our art analogy, each of these observations is allotted its own color selection from a wide pallet. By plotting all of these colors we can offer a representation of the underlying utility like a Pointillist or Impressionist would paint a landscape. SD would merely generate a dark box over the period of these observations, representing the summation of all of the colors that have been plotted by the individual at each observation or transaction. On the topic of transactions, how does SD offer an aggregate investor utility reading from a security's CDF? Each transaction involves a buyer and a seller at time t. If at time t +1 the price has increased, signifying an increased utility for the buyer, how does SD account for the negative utility experienced by the seller? We know that losses hurt more than winners so the net change in utility for any move in a security will be negative, in essence continuously generating negative utility when accounting for the sellers. A decrease in the price will generate net negative utility over that observed period since the loss experienced by the buyer will outweigh the positive utility enjoyed by the seller. If a return distribution from an individual investor's monthly statements were generated, it would be possible to examine their utility from their investments, however, the security returns themselves aggregate the investors' transactions to a point whereby that same level of information cannot be extracted and extrapolated. Because human behavior is heuristic, adaptive, and not completely predictable-at least not nearly to the same extent as physical phenomena-modeling the joint behavior of many individuals is far more challenging than modeling just one individual. Indeed, the behavior of even a single individual can be baffling at times, as each of us has surely experienced on occasion. (Lo, 2004). Ignoring the previous quandary, how does SD generate efficient portfolios, since no algorithms currently exist? These questions directly challenge the notion of SD being a preferred

45

method of utility analysis as a compensation for the specification error a parametric function would generate. So, we can accept some degree of specification error but enjoy greater

discriminatory power or we can give up some discriminatory power to be satisfied we avoided specification error. We contend the image revealed from our function will more than compensate for the unavoidable specification error.

46

APPENDIX B The following pages in this appendix will highlight different benchmark scenarios and configurations. All of the prior figures are symmetrical and were not intended to be an actual representation. We will first illustrate the single benchmark utility graph and place the isolated crop examples from above to put some additional visual context to the text as well as defining the ranges for the certainty equivalent and tangible utility. From there we will put some more visual explanation to the multiple portfolios example. The next set of graphs will illustrate the different LPM configurations due to the wealth effect, increasing the loss sensitivity parameter n, decreasing the LPM, and finally the simultaneous effects of altering both loss sensitivity tools.

47

ONE SINGULARITY UTILITY

80

60

CERTAINTY EQUIVALENT DOMINATES TANGIBLE UTILITY

40

20

UTILITY

CASH CROP ( lower bound by acreage)

CASH CROP (upper bound by acreage) FOOD CROP Example - isolated (bound by acreage)

-20

-40

-60

-80 7 6.5 6 5.5

LOSSES

4.5

3.5

2.5

1.5

0.5

0.5

1.5

2.5

3.5

GAINS

4.5

5.5

6.5

Investor wealth obviously binds the negative utility. As one approaches 0 wealth the utility decreases exponentially.

Outermost LPM associated with Roy's subsistence level S.

Outermost UPM associated with an individual's consumption satiation benchmark

Finite amount of wealth binding the whole function. Utility will not be bound by law of diminishing marginal utility, it's expanding non-tangible marginal utility beyond personal satiation.

*SYMMETRICAL FOR ILLUSTRATION ONLY. 48

MULTIPLE SINGULARITY UTILITY

80

60

40

20

PORTFOLIO 1 SHORT DATED DASHED LINES

-20

-40

UTILITY

PORTFOLIO 2 LONG DATED SOLID LINES

-60

-80

7 6.5 6 5.5

5 4.5 4

3.5 3 2.5 2

1.5 1 0.5 0

0.5 1 1.5 2

2.5 3 3.5 4

4.5 5 5.5 6

LOSSES

GAINS

If portfolio 1 falls beyond your accepted loss parameters, you have entered a lower utility subset where your overall wealth will be marginally dictated then by portfolio 2. All is not lost.

If portfolio 1 outperforms, it will thrust you into a higher utility subset, offsetting any losses to portfolio 2. Robbing Peter to pay Paul with mental accounts. Your overall wealth will then be marginally dictated by the performance of portfolio 2.

If portfolio 2 also falls beyond your accepted subsistence level S, each additional loss amount is exponential until you reach 0 wealth as personal consumption requirements are eroded.

If portfolio 2 outperforms and your personal consumption utility is satiated, each additional amount of wealth will be exponentially greater. You are only bound by the amount you can gather.

*ASSUMING A 2 PORTFOLIO INVESTOR. CAN BE EXPANDED TO MULTIPLE PORTFOLIOS WITH EQUAL BENCHMARKS REPRESENTING AN INDIVIDUAL'S OVERALL WEALTH.

6.5 7

49

WEALTH EFFECT ON SINGULARITY UTILITY

80

60

40

20

UTILITY
0 -20 -40 -60 -80 -100

LOSSES
5 4 4.5

GAINS
4 4.5

6.5

5.5

3.5

2.5

1.5

0.5

0.5

1.5

2.5

3.5

5.5

As overall wealth increases (blue function), LPM and UPM will shift left representing an increased ability / propensity to gamble house money effect, reducing the certainty equivalence for UPM. Downside tolerances are also increased highlighting the effect of accumulated wealth on the investor's core subsistence level. A decreased overall wealth (red function) will shift LPM and UPM to the right, illustrating the increased effect of any losses to a poorer individual as it is closer to encroaching upon their basic necessities (Roy's subsistence level S) as well as the increased amount to reach personal consumption satiation.

6.5

50

INCREASED LOSS AVERSION WITH INCREASED LOSS EXPONENT (n)

100

50

UTILITY
-50 -100 -150 -200
7 6 5 4 3 2 1 0 1 2 3 4 5 6 6.5 5.5 4.5 3.5 2.5 1.5 0.5 0.5 1.5 2.5 3.5 4.5 5.5

LOSSES

GAINS

Same LPM, only one of 2 methods to configure sensitivity to loss. This utilizes the exponent n. The dashed line represents an increased loss exponent function. The inverse is true of UPM.

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51

INCREASED LOSS AVERSION WITH DECREASED LPM

80

60

40

20

UTILITY
0 -20 -40 -60 -80 -100

LOSSES
5 4 4.5 3.5

GAINS
4 5 4.5

6.5

5.5

2.5

1.5

0.5

0.5

1.5

2.5

3.5

5.5

The other tool for configuring loss aversion is by decreasing the lower benchmark or LPM. These two functions have the same exponents, only the dashed one has a decreased LPM highlighting the earlier point at which losses exhibit concavity. The LPM shift also represents a completely different benchmark and is not transitive ( 3 LPM reading for each function represents 2 different levels of negative utility based on its relation to its benchmark). The main takeaway is that one will reach maximum negative utility quicker as 0 wealth approaches. The inverse is true of UPM and the earlier point of convexity.

6.5

52

INCREASED LOSS AVERSION WITH DECREASED LPM AND INCREASED LOSS EXPONENT (n)
100

50

UTILITY

-50

-100

-150

-200

LOSSES
5 4 4.5 3.5

GAINS
4 5 4.5

6.5

5.5

2.5

1.5

0.5

0.5

1.5

2.5

3.5

5.5

The effects of simultaneously increasing both loss sensitivity tools.

6.5

53

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