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

Parimutuel betting markets are simplified financial markets, andcan thus provide a clearer view of pricing issues which are more complicatedelsewhere. Though empirical studies generally conclude thatthe parimutuel betting markets are surprisingly efficient, it is alsofound that for horses with lowest odds (favorites), market estimatesof winning probabilities are smaller than objective winning probabilities;for horses with highest odds (longshot), the opposite is observed.This phenomenon, called the favorite longshot bias, has many explanationssuch as risk seeking preference, transaction costs, and non-lineartransformation of probabilities into decision weights, etc. This papercombines loss aversion with mental accounting, and provides a new explanationfor the favorite longshot bias. We show that the bias existsin the absence of all above mentioned reasons, and the degree of thebias differs depending on the type of the mental accounting processthat bettors apply.