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ECON 4370 Exam 2 Review
Terms in this set (64)
a situation in which there are multiple potential payouts for the participant and the method in which the eventual outcome is chosen contains a random component. probabilities all add up to one, so that all are accounted for.
The reluctance of a person to accept an uncertain bargain with a higher expected payoff rather than a more certain bargain with a lower expected payoff. When the higher payout is less likely, but the lotteries pay the same on average, you will choose the lower max payout option because it is safer.
Unwillingness to take a "fair gamble" when price = expected value or when price is greater than or equal to expected value. Only take gamble with price is less than expected value.
(Condition in which an individual prefers receiving a fixed amount of money with certainty over a lottery with the same expected value but a positive probability of receiving some amount lower than the fixed amount of money.) (A human reaction when exposed to uncertainty in an attempt to reduce that risk)
Can be detrimental to the individual's economic well being because it can cause investors to end up with a smaller amount of money at retirement age. This is because in the long run, if you continuously turn down gambles where price is greater than or equal to expected value, you will end up with less than the expected value which makes you worse off. If they took he gamble every single time, yes there would be losses at points, but in the long run individuals end up with more money than if they turned down the gamble and were risk averse every time.
The Allais Paradox
Expected utility maximization does not always accurately predict human behavior. No matter what an individual's utility function looks like, under the assumption that everyone maximizes expected utility, choosing A in the first set implies that he or she must prefer A in the second, and choosing B in the first set implies that he or she must prefer B in the second set.
(If individuals would choose A in one set and B in the other, that implies, when faced with uncertain choices like these, those same individuals do not act in a way consistent with the maximization of expected utility. demonstrates that expected utility theory is a flawed representation of how humans make decisions under uncertainty)
S Curve (Prospect Theory**)
When facing potential losses, individuals become risk loving rather than risk averse. This occurs irrespective of their initial levels of wealth. All that matters is that they take their current levels of wealth as their reference points and face losses from there.
For gains, an individual's utility function is concave, representing his risk AVERSION. For losses, the utility function is convex, representing risk-LOVING behavior.
Loss Aversion (**)
Losses hurt much more than commensurate gains help (System 1 is heavily affected) (=prospect theory). People's tendency to strongly prefer avoiding losses to acquiring gains. Loss of same amount is more painful than gain of same amount is pleasant from the same reference point. SEE S CURVE.
Prospect theory (**)
Risk aversion for gains; risk avoidance for losses; loss function steeper than gain function. People make decisions based on the potential value of losses and gains rather than the final outcome, and that people evaluate these losses and gains rather than the final outcome, and that people evaluate these losses and gains using certain heuristics.
Theory of decision making under risk. Accounts for loss aversion, diminishing sensitivity, and reference points. Loss aversion says that a loss of some amount is more painful than a gain of same amount from the same reference point is pleasant. The pain of losses and pleasure of gains diminishes as you get further from the reference point. People are risk seeking with losses and risk averse with gains. SEE S CURVE.
(One must look at both at each movement of wealth in turn because the path one takes to get from initial wealth to ending wealth impacts the overall change in happiness. Decisions in the face of uncertainty are path dependent (based on reference points). Prospect theory is about loss aversion)
(*Fails to account for regret and disappointment)
Prospect Theory in Finance
If investors consider paper gains and losses each time they check their portfolios, then not only will the loss aversion tend to drive their choices, but the frequency with which they check their portfolios will greatly affect the decisions they make as well.
(Theory will define outcomes as GAINS and LOSSES, not as states of wealth)
3 cognitive Features of Prospect Theory (in terms of Finance)/Three foundations of loss aversion
1) Evaluation is relative to a neutral reference point, which is sometimes called an "adaptation level"
(i.e. the outcome you expect, the outcome you feel entitled to, the raise your colleagues receive, etc. Above this = gain. Below this = loss.)
2) A principal of diminishing sensitivity applies
(i.e. the difference between $900 and $1,000 is much small than the difference between $100 and $200)
3) Loss aversion: losses loom larger than gains (psychological factor)
Drawbacks of Prospect Theory
Prospect theory does not deal with the effect of disappointment and it can't account for regret.
Should be kept out of intro texts because it undermines expected utility theory, which is the basis of intro texts. EU deals with preference ordering that is constant and rational and is easily applied to simple economics models. Students wouldn't be able to master this basic econ eval if they were confused by the nuance that prospect theory offers for decision making under risk.
occurs when an individual has difficulty figuring out what the problem is that needs to be solved
Saliency/Availability (perception bias)
If an event has not occurred recently, then that event tends to be perceived as having zero probability of occurring in the future. If you have been recently exposed to something or reminded of something, you are more likely to choose that which is more "salient" or "available" to you. Not all contingencies are represented in the decision maker's thought process. if an unlikely event occurs, it is overstated.
(During an economic boom, people forget that crashes can occur and underweight their likelihood of occurrence. ) (When a black swan event occurs, and you irrationally overweight the likelihood of it occurring again)
Framing (**perception bias)
How the question is phrased - answer should be independent from this. The same answer should be given to questions that vary only in phrasing but are substantively identical (invariance). Takes advantage of loss aversion.
(Exploits our attitude toward bad events - see example of choosing how many people live vs choosing how many people will die in population)
the same answer should be given to questions that vary only in phrasing but are substantively identical
(Simple choice among lotteries verifies its failure)
The outcome choices are the same in both problems, just written from a different standpoint. But that different standpoint motivates people to make different decisions. Individuals may be risk averse when considering gains but risk seeking when considering losses.
(ex: Problem 1 is written in the context of saving lives, while Problem 2 is written from the viewpoint of people dying. Respondents consider saving zero people the reference point in the former and zero people dying the reference point in the latter.)
Arises when you are attempting to make a guess at something about which you have limited information. An anchor biases your guess in the direction of the anchor. Perception bias triggered by anchoring can lead to biased behavior that may be in the interest of the person providing the anchor. Lazy thinking.
(Includes "anchoring and adjusting": Was Ghandi more or less than 144 when he died?)
Involves something left out of the utility function, which does effect decisions - regret. Paying for something and then using it are two completely separate decisions. Ticket is viewed as a sunk cost.
(Bias an investor shows when reluctant to purchase a stock at a cheaper price. Investors who "go to cash" in the midst of a financial crisis are sometimes disappointed that, after they sell out of the market, stocks rally to higher prices. )
Endowment Effect (**)
Treat items differently when you possess them and give items you possess a higher value.
This implies the status quo effect because you value things you possess more highly (endowment effect) because of the tendency to not make a change (status quo).
People are willing to pay more to retain something they own than to obtain something owned by someone else. This is because the idea of losing something is negatively perceived, and humans are loss-averse. Indifference curves are not reversible. Willingness to accept compensation is greater than willingness to pay for it once property rights have been established. 2:1. Mug example. People will value a good they own more than identical good they do not own.
(Also, people's WTAccept compensation is higher than their WTP because they are averse to losses, and the idea of selling their object is perceived as a "loss") (Ex: mugs and pens)
Status Quo Effect (**)
Tendency to not make changes and instead stick with the default option.
People will tend to stick with the defaults except when they find them significantly unpalatable and that then and only then will they make a change. Many individuals might consider the default option as their reference point, considering losses and gains from that point in making their decisions. An irrational preference for the current state of affairs.
(also helps avoid regret, which prospect theory can't explain) (An irrational preference for the current state of affairs)
The idea of closing out an account and locking in a loss weighs heavily on an investor's mind. It often feels better to close out a winner and lock in a gain, even despite the tax benefits, and even if the loser is likely to become an even bigger loser. (Prospect Theory) Make decisions based on mental accounting. More apt to sell winning stocks than losing ones, even if the winning stocks have better future potential. Losses evoke such a negative emotion that this force outweighs the motivation to invest in such a way as to maximize the expected return.
Ignoring base rates in favor of something that seems causal. The tendency of most people to read too much into stereotypes. (see Tom W's Specialty) Task is to calculate the conditional probability.
One sin of representativeness is an excessive willingness to predict the occurrence of unlikely (low base-rate) events.
Second sin of representativeness is insensitivity to the quality of evidence (System 1 WYSIATI))
(LESS IS MORE?!?!)
judge a conjunction of two events (bank teller and feminist) to be more probable than one of the events in direct comparison. occurs when it is assumed that specific conditions are more probable than a single general one.
Small Sample Bias
The strong bias toward believing that small samples closely resemble the population from which they are drawn.
(Extreme results are much less likely to occur as the sample size increases) (Ex. cancer in rural counties)
Law of Small Numbers
Individuals tend to put more stock into observations of a small sample of data than is warranted
(Financial traders make decisions on trading strategies based on only the past ten years of data, may be putting too much stock into a small data set)
People tend to overestimate the probability of events for which they have a large bank of relevant memories or stories relative to the probability of other events.
departure in inference or judgement from objective analysis that leads to a distortion in perception or understanding
Illusion of Skill
tendency for people to think they have an ability to execute a particular task when the evidence shows that they are no better at it than random chance.
(Example: the casual market trader who believes he can pick stocks that will beat the market. Malkiel - on average no one beats the market)
Illusion of Superiority
The average person thinks he is above average; positive personality information is recalled more easily than negative personality information (more difficult to process in the mind)
(this can be seen with investment professionals who believe that they are among the few that can beat the market)
Illusion of Validity
individuals tend to believe the conclusions they draw from a brief set of observables are more likely to be valid than they actually are, and this tendency holds true even in the face of clear evidence to the contrary. Israeli military example.
(tied to illusion of control)
Illusion of control
individuals tend to believe they have more control over the outcome of random events than they actually have, even when the events are explicitly constructed as random.
"Law of least effort"
if there are several ways of achieving the same goal, people will eventually gravitate to the least demanding course of action
Regression to the mean
Success = talent + luck
(Causal explanations will be evoked when regression is detected, but they will be wrong because the truth is that regression to the mean has an explanation but does not have a cause - cause is usually luck)
Equity Premium Puzzle
Expected Utility Fails to Provide an Explanation (too much risk aversion) but loss aversion provides simple explanation.
Equities offer a higher return than bonds but this comes with more risk. Risk aversion alone cannot fully explain why investors underweight equity when the premium exists. But people invest in bonds because of loss aversion. Can't take the loses.
(But, Jorion and Goetzmann on survivor bias...)
the difference between the actual payoff and the payoff that would have been obtained if a different course of action had been chosen.
(also called opportunity loss or difference regret)
Availability Heuristic (see Saliency)
Mental shortcut that occurs when people make judgments about the probability of events by how easy it is to think of examples. Estimate frequency, with cognitive ease, which with the event comes to mind. Goes along with substitution; when asked a question, you think of something easier to answer.
The case of which something come to mind, saliency, can effect our estimates of probabilities if a rare event comes to mind very easily.
Bernoulli essentially invented concept of utility: people value money in terms of how much money they already have. A risk-averse decision maker will choose a sure thing that is less than expected value of a gamble, in effect paying a premium to avoid the uncertainty. Expected utility hypothesis.
Khaneman doesn't think he's taken into account changes of wealth in respect to a reference point (important for certainty effect). He doesn't account for regret.
Change in value matters. Only focused on states of wealth and not reference points from which change occurs which is important.
(Wealth is $4 but they both might not be equally happy because one lost a few dollars but the other didn't; expected utility says they both will be happy)
Intuitive; thinking fast. Preferences, feelings and inclinations are endorsed by system 2 into beliefs. Cognitive easiness, associative memory, surprising from normal. More sensitive to changes than to states.
More strongly responds to losses.
(Combo of a coherence-seeking System 1 with a lazy System 2 implies that System 2 will endorse many intuitive beliefs, which closely reflect the impressions generated by System 1.)
Allocates attention to the effortful mental activities that demand it, including complex computations. System 2 operations require attention and are disrupted when attention is drawn away. System 2 often may have no clue to intuitive error so they can't avoid biases.
WYSIATI (What You See Is All There Is)
Facilitates the achievement of coherence and of cognitive ease that causes us to accept a statement as true. Explains why we can think fast. Much of the time, the coherent story we put together is close enough to reality to support a reasonable action.
(Explains a long and diverse list of biases of judgment and choice: Overconfidence (supress doubt and ambiguity); Framing effects; Base-rate neglect)
Engine of capitalism
Overconfidence; Small businesses/entrepreneurs are overly optimistic, exaggerate ability to forecast
(planning fallacy). Overconfidence and innovation.
Overly optimistic entrepreneurs who over-estimate their chance of success are fueling the "engine of capitalism" with innovation and progress because if they were not overly-optimistic and biased then they would not even bother to try and without entrepreneurs there is no capitalism.
The expected value of a gamble is the average of its outcomes, each weighted by its probability. This is not how humans really value things.
(Bernoulli applied this to psychological value. He said that the personal utility of a gamble is the average of the utilities of its outcomes, each weighted by its probability)
highly unlikely outcomes are weighted disproportionally more than they deserve.
outcomes that are nearly certain are given less weight than their probability justifies
Look at decisions individually (i.e. don't think of combinations of decisions)
A single comprehensive decision (i.e. add the expected values of the decisions together to come up with the optimal outcome) (cures loss aversion by aggregating decisions.) (traders typically think broadly)
We separate our money into accounts (e.g. spending, savings, education, medical or cash vs. credit) and feel differently about pulling money from each pool. This is a form of narrow framing to keep things under control mentally.
Tendency to place different items into separate "mental accounts" and treat them differently.
The happiness a consumer derives from a bundle of goods. Each bundle has a number that represents how happy that bundle makes the consumer.
Mapping of every potential bundle a consumer might enjoy.
Three characteristics of a utility function
Universality, comparability, transitivity
Implicit memory effect in which exposure to a stimulus influences a response to a later stimulus.
Reading into Randomness
A trader that finds a pattern in a random assortment of data may pay a big price for his mistake. BGBGBG vs BBBGGG.
Illusion of Talent
People providing too much attribution of a given observation to an individual's talent and not enough to luck. Confirmation bias.
Tendency for people to focus on evidence that confirms their beliefs rather than view the entire set of observations objectively.
average value, weighted by probabilities. EV = P(A)A + P(B)B + P(C)C ...
average utility, weighted by probabilities. EU = P(A)U(A) + P(B)U(B) + P(C)U(C) + ...
A rule of thumb, or quick automatic answer used by System 1, usually right, but they can be flawed and biased
came up with formula to predict achievement that looked at high school GPA and 1 aptitude test. had better predictive power than clinical assessment. good algorithms are better than subjective observations.
Presenting the same information in two different ways. Can lead to preference reversal.
When price of gamble = expected value of gamble
Suggested values that are stated and stick in your mind. Future estimates will start at the anchor and adjust away from it incrementally.
Making a different decision based on the same information at two different times. Could be due to framing, anchoring, availability, or representative biases and heuristics.
Compare loss aversion and risk aversion.
Risk aversion is unwillingness to take a fair gamble. If the gamble was a coin toss where you'd get $10 for heads and -$10 for tails, the expected value would be 0 and a risk averse person would not play because price could never be below expected value. Loss aversion says that if they played the game a gain would not be as pleasant as a loss would be painful.
Endowment Effect example
Mug example. There are three groups: sellers who start with a mug, buyers who don't have a mug, and choosers who can either take a mug or the money. A leader calls out prices increasingly and the three groups either sell, choose or buy. Result: sellers who start with a mug start selling at a higher price than the buyers stop buying because the sellers who started with a mug value it more highly because of the endowment effect.
Status Quo Effect example
On retirement account papers, people stay with the default asset allocations and tend not to make a change. Tendency to abide by this effect is bad for individuals because they will stick with default settings even if its not in their best interest. For example, if the default asset allocation for your job's pension fund is overweighted with bonds and fixed income and you don't change it you will end up with less money and be worse off then if you had changed from the default and gone with more equities.
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