Pragma Synesi – interesting bits

Compendium of interesting bits I come across, with an occasional IMHO

Investing or on game shows, humans act irrationally

From the Investment Executive’s December 2007 edition:

Take a big risk, add a big reward and mix with optimism

Game-show contestants display the same, unfathomable behaviour as investment decision-makers

Traditional econom–ics is unable to explain why people make certain financial decisions. But watching TV game shows may, suggests Thierry Post, a finance professor at Erasmus University in the Netherlands.Post is one of a small group of economists who study game shows, analysing the choices contestants make and the potential clues the shows may offer for economic behaviour in everyday life. The popular U.S. show Deal or No Deal has attracted Post’s attention, largely because it involves no skill whatsoever, which reduces the variables when comparing subjects. It does, however, involve significant amounts of money.The contest works like this: 26 models each hold a briefcase that contains a sum of money rang-ing from US1¢ to US$1 million. Without knowing the amounts in the briefcases, each contestant picks one briefcase as his or her own and begins to open the other 25 one at a time, revealing a little more about what the chosen case may hold. At the end, contestants can trade the earmarked briefcase for the last unopened one.As cases are eliminated, contestants are periodically offered a sum of money that approximates the potential value of their prize. They can stop playing and take the money, or continue to take a chance of earning more with the briefcases. In the later rounds, the expected value of future offers can change drastically as briefcases are eliminated.

If contestants just wanted to maximize the expected value of their winnings, they should always turn down the offer. But many eventually accept. Are they behaving rationally?

Say, for instance, the last two briefcases hold US$1 million and US$10, and the offer is US$450,000. With a 50/50 chance at $1 million, probability theory suggests the expected value is the average of the two unopened briefcases, or US$500,005. Classical economic theory says that when the amount involved becomes a significant fraction of their net worth, contestants become more risk-averse and more willing to accept a sure amount than an expected higher amount.

But this isn’t always the case, Post notes. The first step is to analyse each contestant by placing numerical estimates on how risky his or her behaviour is, he says.

Under the hypothesis that contestants actually weight the value of each possible outcome by the probability of that outcome, Post placed upper and lower bounds on a contestant’s degree of risk aversion to get a sense of when he or she is likely to abandon the risks of the lottery for the sure thing.

He attempted to identify the point at which contestants are neutral about accepting and rejecting the offer, from which he then inferred a mathematical variable for each individual. A smaller measure means it takes a larger offer to dissuade a contestant from continuing the game; a higher value means the contestant dislikes risk and will accept a smaller offer.

Not only did contestants’ behaviour differ, but individuals also exhibited a wide range between upper and lower bounds. To Post, this indicates the behaviour of many contestants was inconsistent, in that they eventually accepted an offer that was less favourable than one they had previously rejected.

Post looked at contestants’ behaviour in previous versions of the show and found their decision-making preferences also varied widely from round to round and from participant to participant.

Players take more risks if they suffer early setbacks, such as opening the million-dollar briefcase. That supports prospect theory that holds that people evaluate prospects for gains and losses from psychological reference points that may shift over time — such as opening high-value briefcases early — instead of trying to maximize the “utility” they receive from money under a rigid formula.

Contestants attach greater significance to unlikely, high-payoff events than the probability of these events occurring warrants. Optimistic or “forward-looking” contestants are more likely to engage in risky behaviour because they either believe in a higher chance of a payoff or think winning big merits the gamble, Post says.

This explains why some people simultaneously buy lottery tickets but still invest their money quite conservatively.

January 10, 2008 - Posted by | behaviour, decision making, economics, investing

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