Using Target-oriented Utility to Elicit Preferences for Taking Risks in Uncertain Financial Markets

Consistent with Bernoulli's interpretation of utility, investment managers determine their clients' preference for risk by directly asking clients about their willingness to take risks. Many investors find answering such questions difficult. Consistent with Simon's theory of bounded rationality, other investment managers ask clients how much money they will eventually want to withdraw from their investment account to meet education, retirement, or other investment goals. Many clients find such questions easier to answer. This paper aims to show how the target-oriented utility integrates these two approaches by interpreting the utility of wealth as the probability of the client needing that level of wealth to achieve their investment goals. In this case, a client's willingness to take risks reflects their uncertainty about how much wealth will be required to achieve their targets. The target-oriented utility predicts loss-aversion during bull markets where winning stocks are sold too early and gain- seeking where losing stocks are held too long in bear markets. Our results offer a normative explanation to the disposition effect, which is the prevalent biased behavior that drives investors to "sell winners too early" in bull markets and to "ride losers too long" in bear markets.