| ashu |
Posted
on 29-Aug-03 05:41 AM
What follows has NOTHING to do with Nepal or the Maoists.
It's just one helluva interesting piece of reading.
Have a great week-end everyone. Isolated Freak, have a great flight to Shanghai;
and Bhunte, have a great trip back to the States.
oohi
ashu
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To have and to hold
Aug 28th 2003
Can people learn to be as rational as economic theory supposes?
FOR several years now, a battle has been raging among economists. On one side are the traditional, neoclassical theorists, who believe that people should be thought of as rational economic agents. On the other are the upstart behaviouralists , who do not accept that people always get their complicated sums right (maximising utility subject to a budget constraint, and all that), or even act as if they do.
A top behaviouralist, Daniel Kahneman, won last year's Nobel prize in economics for pointing out the differences between Homo sapiens and H. economicus. Real people tend to judge their well-being relative to others, not in absolute terms; their actions depend on the way choices are presented; they fear loss more than they crave gain. Such insights form the core of what is known as prospect theory .
Some economists think that prospect theory can overthrow two centuries of neoclassical thought. Others say that it only gives credence to the idea that people repeatedly make daft mistakes. Is there a way of settling the dispute?
Some recent work should at least help. It explores the endowment effect , one of the chief tenets of prospect theory. Put simply, this means that people place an extra value on things they already own. Think of a favourite sweater, or your house: would you swap either for something of equal market value?
Over the past decade, prospect theorists have found support for the endowment effect in scores of experiments. In one of the best-known, researchers at Cornell University began by giving university students either a coffee mug or a chocolate bar, each with identical market values. First the experimenters confirmed that roughly half the students preferred each good. After the goodies were handed out, they let the students trade: those who had wanted mugs but got chocolate (or vice versa) could swap.
With barely 10% of students opting to trade, the endowment effect seemed established (you would expect 50% to have swapped, given the random allocation of gifts). Even after a short time with things of little value, ownership had overwhelmed the students' prior tastes. Dozens of other tests have produced similar results, and have produced a wave of criticism of neoclassical economics.
The criticism has been taken seriously, as it should be: if the endowment effect is real, people's economic decisions are fundamentally different from what economists have assumed. The implications of this are profound. To take one example, the Coase theorem, which argues that initial allocations of wealth do not matter as long as markets allow people to trade their stakesthe rationale for government auctions of everything from radio spectrum to mobile-telephone licenceswould no longer be valid.
To take another, although economists have shown that you need only a few sharp traders for prices in financial (and other) markets to become efficient, the volume of trade with an endowment effect will be below what it might be without one.
John List, an economist at the University of Maryland, recently tested the existence of the endowment effect in a new way. Instead of using callow students, he went to a real market with traders of varying degrees of experience: a sports-card exchange, one of many such, where Americans trade pictures of their favourite athletes. There, traders dealing in hundreds of cards mix with browsers who might buy only one.
In one experiment*, Mr List took aside a group of card fans and gave them an assortment of other, less familiar, sporting memorabilia, such as autographs, badges and so forth. He then let them trade. The less card-trading experience a subject had, the less likely he was to trade, even when a good deal was on offer. More experienced traders were less prone to the endowment effect, and traded as keenly as neoclassical theory predicts.
News from the swaps market
Although consistent with an endowment effect, this was not proof of one. Novice traders could simply be wary of dealing with those who might get the better of them. To rule this out, Mr List concocted another experiment along the lines of the Cornell study . He gave a similar cross-section of fans chocolate and coffee mugs, whose values are well-known even to the most inexperienced bargainers, and let them trade. Again, Mr List found evidence for an endowment effectbut also that long experience as a card trader spilled over into his experimental mug-and-chocolate market. Only novices, like the students in earlier experiments, tended to be swayed by what they had been given.
This implies that prospect theory can capture the behaviour of inexperienced people, of which the world has many in all sorts of markets. But experienced buyers or sellers in well-established markets get over their psychological flaws . They can even transfer their trading skills from one market to another. The neoclassicals, it seems, have scored a point.
Mr List notes that sellers seem to learn how to trade faster than buyers do. What might this imply for, say, stockmarkets? The green investors who discovered shares only when markets boomed in the 1990s had been slower than others to part with their cash and join in. But once in, were they afflicted by the endowment effect? Owning Amazon shares bought for $400 each made it hard to sell until much higher prices came along (they didn't). Sophisticated traders, especially the sell sides of investment banks, had no such baggage, and sold. The bear market, however, should have proved as good a learning experience as novice investors are likely to get.
http://economist.com/finance/displayStory.cfm?story_id=2021010
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| Brook |
Posted
on 29-Aug-03 06:54 AM
Interesting read.
The one other enhancement prospect theory brings to the analysis of choice under uncertainty using the standard subjective expected utility framework is the aspect of loss aversion. Loss aversion is simply an experimentally verified investor characteristic that motivates him to aggressively seek risk in the domain of imminent loss while to be generally risk-averse when the expected value of the risky gamble is positive. So, in essence, while utlity is defined over aggregate wealth levels, and investors generall assument to be risk averse under the subjective utility framework, prospect theory takes potential net gains and losses to evaluate investor behaviour and allows for investors to be excessively bullish as well.
Although prospect theory adds a whole new dimension and credibility to the emerging school of behavioral economics [it has been used to explain various "anomalies" like the equity premium puzzle and excess volatiliy in stock market data], it has to do a whole lot more to be able to replace Eugene Fama's 33- year old Efficient Market Hypothesis as a normative paradigm. To the staunch supporters of the Hypothesis that has remained the principal building block of modern finance, the major weakness of prospect theory or behavioral finance as a whole, is their inability to provide a statistically testable null hypothesis.
But then again, there are some others who believe that the very success of prospect theory as a rapidly growing alternative to the subjective expected utility way of modelling choice under uncertaintly is because of its LACK of normative ambitions.
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| gokul |
Posted
on 29-Aug-03 08:18 AM
Expected Utility Theory was proposed by Von Neumann and Morgenstern. Subjective Expected Utility, which uses subjective measure of individual's probability assessment, originated with the seminal work of Savage. Both of these frameworks are limited in the sense that they assume individuals always perceive utility in terms of aggregate wealth, i.e. they add their gains/losses on top of their existing wealth in assesing the utility of a prospect (gamble).
Prospect theory, developed by Kahneman and Tversky, consists of two parts: value function and probability decision weight function.
The implications of the value function is that:
(1)individuals are sensitive only to gains and losses, and not on their aggregate wealth.
(2) individuals are risk averse in gain (concavity) and risk seeking in loss (convexity).
(3) individuals are more sensitive to loss than to gain (loss aversion).
The implication of probability decision weight function is that
(1) small probabilities are over-weighted: This explains why people buy lotteries and insurances.
Behavioral finance started with the paper by DeBondt and Thaler (1985) in which they found that people overreact in stock markets. Furthermore, they found systematic biases in people's behavior that challege the "Rationality" assumptions of modern economics and finance. The following two principles are the foundation of behavioral finance (Shleifer and Summers):
-Limits to arbitrage
-Psychology
Needless to say, BF uses Prospect theory. The main challege to behavioral finance is to come up with a unified framework that can explain these multitudes of so-called psychological "effects". The beauty of modern finance is its unified framework based on a few simple principles, viz. CAPM, portfolio theory, EMH, and derivatives pricings.
Unless Behavioral finance succeeds in unifying its findings in a coherent way, it will just be an "anomaly literature" however interesting it may sound at times.
Gotto go, more later if anyone is interested.
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