2 - Expected Utility Anomalies/Empirical Violations Flashcards
Do people tend to overweigh low or high probabilities?
People tend to overweigh low probabilities (choose a higher probability over a low probability prospect even if the expected outcome of each is the same) and the effect is greatest at very low probabilities.
What is the lottery effect?
People are often willing to accept a high probability of poor returns for a small chance of earning large returns.
Describe insurance need
People tend to choose prospects with guaranteed small losses even if the chance of a loss is very small with another prospect if the potential loss is very large.
How does framing affect decision making?
When framed as a gain, people tend to be risk averse; when framed as a loss, people tend to be risk-seeking.
What is zero risk bias?
The preference for reducing a small risk to zero over a greater reduction in a larger risk. For example, effort spent on making air travel safer is greater than road traffic even though road traffic causes way more deaths.
What is a consequence of zero risk bias to investors?
One consequence of this bias is that risk averse investors prefer small benefits which are certain to larger ones which are uncertain (e.g., risk-free returns versus investing in risky stocks).
What is the certainty effect?
People tend to prefer a prospect with a certain outcome over one with an uncertain outcome even if the expected outcome is the same.
What is normalcy bias?
People tend to underestimate both the possibility of a disaster occurring and its possible effects (low probability/high impact events). In the case of actual disasters people are prone to deny that they are occurring or to recognise potential real dangers (e.g., tsunamis). May result in people being underinsured unprepared for changing economic/financial circumstances.
