Loss aversion and mental accounting: the favorite-longshot bias in parimutuel betting

Abstract

It is shown that in the framework of prospect theory, the combination of mental accounting and loss aversion can fundamentally change the way individuals evaluate risky alternatives. This finding is then applied in a market setting: parimutuel betting markets. In parimutuel betting markets it has been found that for horses with the lowest odds (favorites), market estimates of winning probabilities are smaller than objective winning probabilities; for horses with the highest odds (longshot) the opposite is observed (the favorite-longshot bias). A game theoretical model is built to show that the favorite-longshot bias can be the equilibrium play of players with loss aversion. Furthermore, the degree of the favorite-longshot bias is influenced by the mental accounting process that players use.