ABSTRACT
In the face of risk and uncertainty, individuals make decisions that are not always consistent with the standard assumption that preferences are represented by an expected utility form. This chapter introduces two popular alternative models. The first is prospect theory. Prospect theory assumes that individuals i) exhibit diminishing sensitivity relative to a reference point, and ii) weight the possible outcomes in a lottery with decision weights determined by a probability weighting function. The model makes sense of multiple anomalies, including the Allais paradox and the tendency for individuals to over-insure themselves against modest risks, while simultaneously seeking out lotteries that increase their exposure to risk. The second alternative model is maxmin expected utility, which assumes that when faced with ambiguity, individuals believe they are facing the worst-case scenario. This model provides an explanation for the observed ambiguity aversion that individuals exhibit in the Ellsberg paradox. The implications of ambiguity aversion for personal finance decisions are considered, including the non-participation puzzle, a preference for the familiar, the home-bias puzzle, and the own-company stock puzzle. The scope for policy to improve individual welfare for those with such nonstandard preferences is briefly addressed.
