Prospect Theory: Curvilinear Relationship

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From present researches, prospect theory argues that decision makers examine gambles in isolation, relative to a reference point and PT also assumed that the current wealth will not influence choice. In Prospect theory model would give an effect to current wealth firm performance if firms make their choice in isolation. Accordance to Kahneman and Tversky’s, prospect theory argued that managers whose firms experience performance evoke a loss context and try to find out riskier alternatives while for those whose always experience better performance evoke a gain context and would choose a less risky alternatives.

Accordance to Fiegenbaum and Thomas, 1988:90,the predictions imply that empirical risk and return studies based on a group composed of both above target and below target firms suffer from a misspecification bias. Other than that, the effect of misspecifications on the risk and return relation at an industry level is unspecified. They tested the predictions of prospect theory using accounting data. Within industries, they divided firms by two group, those the above target returns and those the below target returns. Besides that, they defined that an industry’s median return as a target, which assuming that each industry, both groups contained an equal number of firms . It also suggests that a gain-loss reference point greater than median target industry presentation could explain some previously reported and theorize that if the reference point is elevated then managers become risk averse.

Based on a theory of individual choices in Prospect theory, a firms assume that firms act as individual who behave according Prospect theory. This would make no sense to assume than individual wealth influences individual choice in PT than it would to assume firms wealth influences firms. Besides that, firm performance or wealth can influences their firm risk behavior. Accordance to Bromiley attempts to create a PT model where firm wealth or performances relative to a reference point would influence the evaluation of choices. Almost all firm facing choices isolation regarding risky outcomes have both positive and negative outcomes and therefore are mix gamble. Besides that, a firm that faced an excess of choices that had all outcomes over the firms reference point would probably raises it reference point in a similar to aspiration adjustment. Only managers whose can see choice with potential negative outcomes as risky, managers would make a decision usually involve mixed gamble.

As a conclusion, I can concluded that a firms with return above target level are risk averse while firms with return below target are risk seeking. This is show that a relationship between risk and return and performance a firms is a very important for firms.