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Absolute vs. Relative Notion of Wealth Changes

Kontek, Krzysztof (2009): Absolute vs. Relative Notion of Wealth Changes.

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Abstract

This paper discusses solutions derived from lottery experiments using two alternative assumptions: that people perceive wealth changes as absolute amounts of money; and that people consider wealth changes as a proportion of some reference value dependant on the context of the problem under consideration. The former assumption leads to the design of Prospect Theory, the latter - to a solution closely resembling the utility function hypothesized by Markowitz (1952B). This paper presents several crucial arguments for the latter approach. That essentially all financial theories consider “returns” expressed in relative terms, rather than “gains” and “losses” expressed as monetary amounts, is one of them. This provides arguments for rejecting the Prospect Theory paradigm.

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