Financial forecasting and risky decisions: an experimental study grounded in Prospect theory
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Financial forecasting and risky decisions: an experimental study grounded in Prospect theory Rodney C. Shrader 1
& Mark
Simon 2 & Steven Stanton 3
# Springer Science+Business Media, LLC, part of Springer Nature 2020
Abstract This study employed prospect theory to examine relationships between effort invested in developing financial forecasts and risk taking. Results of an experimental study indicated that the more effort subjects invested in developing forecasts, the more likely they were to use those forecasts as their reference points when evaluating venture performance. Results also indicated that subjects who used forecasts as their reference points and exerted greater effort developing those forecasts were more likely to take risky actions when performance fell below their reference points. This study is the first to link effort to the type of reference point used and the first to link effort and the use of financial forecasts to risky decisions. In addition, it is one of only a few studies to employ prospect theory to examine risk taking decisions subsequent to start-up. Its results enhance our understanding of risk taking, prospect theory and reference points. Keywords Risk taking . Financial forecasting . Prospect theory
Introduction Risk taking is an inherent part of entrepreneurship (Cramer et al. 2002; Hvide and Panos 2014). In addition to their initial decisions to launch new business ventures, entrepreneurs must decide whether or not to take other risks such as expanding production, entering new markets, or introducing new products. Each investment they make includes inherent risk regarding the likelihood that the investment will pay off.
* Rodney C. Shrader [email protected]
1
Denton Thorne Chair in Entrepreneurship, College of Business Administration, University of Illinois at Chicago, 815 W Van Buren St., Suite 400, Chicago, IL 60607, USA
2
School of Management, University of Michigan—Flint, 2129 Riverfront Center Building, 303 East Kearsley Street, Flint, MI 48502, USA
3
420 Elliott Hall, Oakland University, 275 Varner Drive, Rochester, MI 48309-4485, USA
International Entrepreneurship and Management Journal
Consequently, risk and risk taking are central issues in the study of entrepreneurship and have been subjects of research since the foundational work of Frank Knight (1921). Prospect theory was introduced by economists Kahneman and Tversky in 1979 to explain risky decisions of individuals and several scholars have suggested that this theory provides a powerful explanation of entrepreneurial behavior (e.g., Estrin et al. 2017; Hack et al. 2016; Hsu et al. 2017; Simon et al. 2003). However, despite its potential value, few entrepreneurship studies have incorporated prospect theory (Baron 2004), and those that have done so focused primarily on decisions to launch or discontinue business ventures. Prospect theory argues that an individual is more likely to make a risky decision when an outcome falls below a pre-established reference point. In the context of entrepreneurship, prospect
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