Experimental test of the prospect theory value function: A stochastic dominance approach

According to prospect theory, individuals are risk averse regarding gains but risk seeking regarding losses, implying an S-shaped value function. The S-shaped value function hypothesis is based on experiments in which subjects are asked to choose separately between alternatives with either only positive or only negative outcomes, alternatives which rarely exist in the capital market. In addition, the S-shaped findings may be biased by the "certainty effect" and by probability distortion. In this paper we employ the recently developed prospect stochastic dominance criterion to test the prospect theory S-shaped value function hypothesis with mixed outcomes and with no "certainty effect." Assuming that subjects do not distort moderate probabilities, we strongly reject the prospect theory S-shaped value function, with at least 76-86% of the choices being inconsistent with such preferences. When possible subjective probability distortions are taken into account, we find that at least 50-66% of the choices are inconsistent with an S-shaped value function. (C) 2002 Elsevier Science (USA). All rights reserved.