Friday, September 11, 2015

Are You Risk Averse? (decision theory, risk aversion, Kahneman, Tversky and Thaler, the usual)

As "Yr. Most Humble Obt. Servt" I need to ascertain your risk tolerance.
Cut the cards for $10 grand?

From ValueWalk:
Loss Aversion – The Certainty Equivalent
One of my students met me in my office the other day. He is a ROTC cadet; that’s Reserve Officer Training Corps, in case you don’t know.

He knows I have military experience, and he wanted to pick my brain about how he could use his MBA while working for the government.

“Uh, you can’t, really,” I said.

So he asks me, “Should I stay in the government or get out?”

At this point I drew him a graph.
Loss Aversion
The x-axis is your ability, competence, IQ, whatever. The y-axis is how much you get paid.
So the government path is indicated by the dashed line. If you’re very smart, you can get paid a little more, but generally everyone gets paid the same no matter how competent or incompetent they are. That’s the government.

But it’s a lot more than what you would get paid in the private sector—unless, unless you are one of those savants like Zuckerberg or the Google Inc. guys or even a smart businessman or talented trader, in which case you can make a lot more in the private sector than working for the government.

But for 9 out of 10 people, no, you should not work in the private sector. You should work for the government.

So I asked him, “Are you one out of those 10 people?”

He said, “I think I am going to keep working for the government.”

Decision Theory
If you’ve ever taken a decision theory class (I have, and it was awesome), this is the first thing you learn.

You have a 50/50 chance of winning $10,000. You have P = 0.5 of getting $10,000 and P = 0.5 of getting 0.

Or you can choose not to play the game and get $3,000.

What do you do?

The answer is: it depends on who you are and what your risk preferences are.

Rationally, the number to get you to walk away should be $5,000. But most people will walk away for less. Sometimes much less. Sometimes people will walk away for $500 or $1,000. After all, it’s money they didn’t have before.

Anyone who accepts less than $5,000 to walk away is known as risk-averse.

Loss Aversion
Here is where things get interesting. Turn the experiment on its head.

Tell people they have a 50/50 chance of either losing $10,000 or breaking even.

Then tell them that they could either take their chances with the 50/50 game or they could lose a certain $2,000.

Faced with this choice, people will roll the dice. Every. Single. Time.

Nobody wants to “lock in” a certain loss. As long as there is a chance that they could break even, they will hope—except hope is not a strategy.

This is known as loss aversion.

If you understand this experiment, you understand half of behavioral finance.

Kahneman and Tversky, and Thaler
I started reading about this in 2004. Daniel Kahneman is quite famous, with his book Thinking Fast and Slow, and Richard Thaler is perhaps even more famous, with his books Nudge and Misbehaving. He is also an advisor to President Obama.

About 11 years ago, nobody outside of geeky financial circles had ever heard of these guys. I was reading their academic papers to get better at my job....MORE