Beginning with the work of Allais in the early 1950s, psychologists and economists have discovered a growing body of evidence on the discrepancy between the prescriptions of expected utility theory and real human behavior. The accumulated experimental evidence has reached a critical point in which a large number of economists share the sharp opinion expressed by Reinhardt Selten (1999):
“Modern mainstream economic theory is largely based on an unrealistic picture of human decision making. Economic agents are portrayed as fully rational Bayesian maximizers of subjective utility. This view of economics is not based on empirical evidence, but rather on the simultaneous axiomization of utility and subjective probability. In the fundamental book of Savage the axioms are consistency requirements on actions with actions defined as mappings from states of the world to consequences (Savage 1954). One can only admire the imposing structure built by Savage. It has a strong intellectual appeal as a concept of ideal rationality. However, it is wrong to assume that human beings conform to this ideal”.
The most natural route to move away from the impasse generated by the experiments of Allais was to consider the theory of expected utility too restricted and therefore to try to formulate an extended theory of expected utility. Many proposals arose in this direction, especially from the mid 70s onwards, all of which based on the attempt of relaxing or slightly modifying the original axioms of expected utility theory. We will cite the following: the Weighted Utility Theory (Chew and MacCrimmon) assumes a weaker form of the axiom of independence; the Regret Theory proposed by Loomes and Sugden (1982), and the Disappointment Theory, suggested by Gul (1991) are further examples along this line.
Despite the great effort that has been dedicated to the attempts to redefine a new non-expected utility theory on the grounds of new assumptions, modifying or moderating certain axioms, none of the alternative theories propounded so far had a statistical confirmation over the full domain of applicability. Moreover, the discrepancy between prescriptions and behaviors is not limited to expected utility theory. In two other fundamental fields, probability and logic, substantial evidence shows that human activities deviate from the prescriptions of the theoretical models.Therefore one may suspect that the discrepancy cannot be ascribed to an imperfect theoretical description of human choice, but to some more general features of human reasoning. Along this line, Kanheman and Tversky’s Prospect Theory provides a new background for a better understanding of systematic deviations from pure rationality.
From Livio Stracca “Behavioral finance and asset prices:Where do we stand?” Journal of economic Psychology 25 (2004):
“Behavioral finance rejects a vision of economic agents’ behavior based on the maximization of expected utility. At the root of this rejection is the overwhelming evidence available that agents, both in controlled experiments and in real life situations, behave in a way so as to violate the axioms of expected utility (Starmer, 2000). It should be emphasized that the focus of behavioral finance is on a positive description of human behavior especially under risk and uncertainty, rather than on a normative analysis of behavior which is more typical of the mainstream approach.
One of the key objectives of behavioral finance is to understand systematic market implications of agents’ psychological traits. The stress on the market implications is very important because the analysis of large, competitive markets with a low level of strategic interaction is at the heart of economics (Mas-Colell, 1999).
So far, the behavioral finance literature has not reached a level of maturity which would allow it to provide a coherent, unified theory of human behavior in market contexts in the same way expected utility and mainstream economics and finance have done. 2 Nevertheless, cumulative prospect theory introduced by Starmer and Sugden (1989) and Tversky and Kahneman (1992) is approaching a point where it can represent a unified theory of behavior of agents under risk which is alternative, and possibly (in some contexts) superior, to expected utility.”