prospect theory

Lee mentioned prospect theory in a comment, but before we discuss behavioral economics, I would like to establish your risk aversion. So please answer the following without thinking too much about it:
Imagine that you delivered a service or job, which is worth 100$ dollars.
Would you prefer to get paid 100$ immediately, or would you be willing to wait 1 week for your payment and receive 101$ then?
This is not a trick question, just a simple question about what you would prefer.


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added later: The 101 option is equivalent to an annualized interest rate of 67% and very few investments provide for this kind of return. One has to either have a very high risk aversion or face severe liquidity constraints to reject it. But if you ask friends or family you will get mixed results (try it).
This kind of delayed gratification experiment has also been performed many times by behavioral economists; in one typical case the interest demanded ranged from 5% to 240% per month . And in the famous marshmallow experiment half the children rejected an offer to double an asset they desired in 15 minutes. Not even high frequency trading can provide for such high returns.

This raises three questions:

i) Why are real interest rates so much lower?

ii) Why do behavioral economists never point out this discrepancy?
In the linked piece a guy who demands 5% per month is described as having a “flat discount function”.

iii) Finally, is behavioral economics relevant for the real economy and financial markets?

In my opinion the answer to i) is quite simple: Real interest rates are not set by cash strapped students or little children or any single person, but liquid markets dominated by large investors. But even an odd lot investor would probably think different about interest rates when she purchases bonds, than when asked the above question.

I admit that ii) is a real puzzle to me, but perhaps I am not familiar enough with the literature.

My answer to iii) is that our everyday experience just does not scale very well to the overall economy and financial markets in particular. There are many reasons why we may prefer the immediate payment of 100$ in everyday life. Perhaps we are worried that we might forget about it, it is a hassle to chase a payment one week later and perhaps such an offer would be somehow strange in real life and raise suspicion. Also, marshmallows taste much better than money.

Don't get me wrong, I think experiments uncovering behavioral bias and economic fallacies are interesting and one should know about them. The sunk cost fallacy is one of my favorites.
But I do not expect that behavioral economics is the secret sauce that will help us understand macro economics or financial markets better. What is missing imho is some kind of "renormalization procedure", which scales individual behavior to macro economics.

8 comments:

Anonymous said...

The 100$ now.

Lee said...

I'm risk adverse. I'd take $100 now. However, I'd wait a year to take $152.

wolfgang said...

Interesting example of an inverted yield curve: You would accept a 52% ann. return for a 1 year investment but reject 67% for the very short term.
8-)

Lee said...

Obviously any rational human being would take the higher short term return, but I've known for a long time I'm not rational. 8-)

When I wrote that I'm risk adverse, I think that is true. But in this case I don't think that is what would guide my actions. I think it would be more along the lines of not caring much about maximizing my wealth, but caring quite a bit about minimizing annoyances. Having to go back in a week or even to just wait a week to collect an extra dollar is an annoyance. Having to go back in a year, is an annoyance that is put off and I'm going to get $52 instead of $1. I'll probably just lose the dollar out of my pocket while I might buy a book or two with the $52. That is actually true. That is how my brain works when it comes to thinking about money. For me that's true for even quite large amounts of money. I'll just let an investment sit at a low return even if I can get a guaranteed higher return just because I don't want the annoyance of fooling with it. So I guess markets are generally efficient, but if I'm at all representative of a population it's not because of rational thinking.

Lee said...

>> Don't get me wrong, I think experiments uncovering bias and fallacies are interesting and one should know about them.

I agree, but I think Kahneman points out somewhere in the book that knowing about them doesn't really change much, if anything, in the way we respond to different situations.

CapitalistImperialistPig said...

I think our biases and so-called fallacies have two origins, the big one being the fact that they were developed by our evolution in a highly uncertain and undependable world which leads us to heavily discount the future. Three year-olds are well aware that they have no power to enforce their contracts, while big banks know that they have a more or less dependable leviathan to do the dirty work.

You point out the other one, which is not unconnected. It's a bother and computational nuisance to keep track of whom owes you an extra dollar, but Lee, anyway, will do the work for $52.

Many of these so-called fallacies stem from assuming that linearity applies in a domain where there is no reason to expect it.

wolfgang said...

>> that they were developed by our evolution
Kahneman has one that you may appreciate:
Something that an animal sees for the first time could be dangerous, something else that has been encountered many times (and survived) is probably harmless.

This explains, according to Kahneman, why a new idea, word, image, etc. is initially met with skepticism and even fear. But we get used to something that is repeated over and over perhpas even by different sources.
So if e.g. Trump and friends keep repeating the same idea over and over (tariffs will bring jobs to US) enough people will get used to it over time and no longer be afraid of it.

Lee said...

>> I think our biases and so-called fallacies have two origins,

I'm pretty sure they only have one origin and that's our evolutionary heritage as you stated. I'm not sure what you were trying to get at with your second origin idea, but if your idea is valid it's a consequence of our evolutionary heritage and not an origin in itself.

Btw, I read a book recently that I think there is some chance you would enjoy if you haven't already read it. It's entitled "The Vital Question" by Nick Lane. Link is below. Maybe getting your mind off of politics for a few hours would be a good thing.

https://www.amazon.com/Vital-Question-Evolution-Origins-Complex/dp/0393352978/ref=sr_1_1?s=books&ie=UTF8&qid=1487550183&sr=1-1&keywords=nick+lane