Questions Flashcards
What does Expected Value calculate?
the average outcome of uncertain events
What is the role of Expected Utility Theory?
extends the calculation of the Expected Value by considering the utility (or subjective value) individuals assign to outcomes, acknowledging that people have different risk tolerances
What is the role of Prospect Theory?
furhter refines the understanding (Expected Value + Expected Utility Theory) by showing how people actually make decisions under risk, highlighting biases like loss aversion and framing effects
Differences between Expected Value, Expected Utility Theory, and Prospect Theory
- Expected Value calculates the average outcome of uncertain events
- Expected Utility Theory extends this by considering the utility (or subjective value) individuals assign to outcomes, acknowledging that people have different risk tolerances
- Prospect Theory further refines this understanding by showing how people actually make decisions under risk, highlighting biases like loss aversion and framing effects.
Give an example of Framing Effect
When a surgery’s success is framed as “90% survive” versus “10% die,” even though the statistics are identical, the former framing makes people more likely to choose the surgery. This is considered irrational because the decision is influenced by how the information is presented, not by the content itself. Prospect Theory explains this by showing that the framing alters the reference point, affecting the perceived value of outcomes
Describe the St. Petersburg Paradox.
This paradox illustrates a situation where a game with an infinite expected value (theoretically offering unlimited earnings) is not appealing to most people because the likelihood of high payouts is extremely low. Expected Utility Theory explains this by introducing the concept of diminishing marginal utility, suggesting that the utility of wealth increases at a decreasing rate, which rationalizes why people would not pay a high entry fee for the game
Describe the Allais Paradox.
This paradox demonstrates that people’s choices can violate the expected utility theory’s prediction, showing a preference inconsistency when faced with certain versus probabilistic outcomes. Prospect Theory explains this using the concepts of certainty effect and non-linear probability weighting, which shows how people overweight certain outcomes and small probabilities, deviating from expected utility maximization.
Describe the Propsect Theory (Insurance and Lotteries)
Prospect Theory explains this contradictory behavior through the value function, which is concave for gains (risk-averse behavior, like buying insurance) and convex for losses (risk-seeking behavior, like playing lotteries), and through loss aversion, where the pain of losing is stronger than the pleasure of gaining an equivalent amount.
When does the Sunk Cost Fallacy occur?
when individuals continue a behavior or endeavor as a result of previously invested resources (time, money, or effort)
Explanations:
- commitment to the decision
- fear of wastefulness
- a desire to avoid regret
What is Mental Accounting?
The tendency to categorize, allocate, and evaluate economic outcomes by assigning them to specific accounts mentally. Example: Treating $100 of gambling winnings differently from $100 of salary
What is Hedonic Framing?
The practice of framing decisions in a way that separates or integrates outcomes to manipulate emotional impact. Example: Preferring to receive two separate bonuses (segregating gains) but preferring to consolidate losses into one
What is Money Illusion?
The tendency of people to think of currency in nominal, rather than real, terms. This can lead to irrational decisions, such as feeling richer despite inflation reducing purchasing power
What is the Equity Premium Puzzle?
The observation that stocks have historically returned significantly more than bonds, more than can be explained by classical financial theories. Myopic loss aversion suggests that investors’ short-term risk aversion and frequent portfolio evaluations can lead to a demand for higher risk premiums for stocks
What is the Disposition Effect?
The tendency to sell assets that have increased in value and hold assets that have decreased in value.
This can be explained by the value function in Prospect Theory, which is concave for gains (leading to risk-averse behavior) and convex for losses (leading to risk-seeking behavior), as well as mental accounting, regret theory, gambler’s fallacy, and wishful thinking
Explain the Equity Premium Puzzle.
The explanations for Equity Premium Puzzle from a behavioral perspective include the influence of psychological biases and preferences that deviate from rational expectations, such as loss aversion and overreaction to recent financial market performance.
What is the role of Exponential Discounting?
Assumes a constant rate of time preference, leading to consistent choices over time.
What is the role of Hyperbolic Discounting?
Suggests that the rate of time preference decreases over time, leading to inconsistencies in choices over time.
Compare Exponential Discounting and Hyperbolic Discounting.
- Exponential Discounting: Assumes a constant rate of time preference, leading to consistent choices over time.
- Hyperbolic Discounting: Suggests that the rate of time preference decreases over time, leading to inconsistencies in choices over time.
People tend to prefer improving sequence (e.g., increasing
salary profile). Why is that inconsistent with conventional time
discounting model in textbooks? What are possible
explanations offered from insights of behavioral preferences?
- suggests people value future gains more when they are seen as improving over time, contrary to the model’s assumption of consistent valuation of future benefits
Behavioral preferences suggest possible explanations, including the anticipation of future happiness, a desire for improvement, and the psychological impact of positive changes over time. These insights highlight the complexity of human preferences beyond simple economic models.
- Why people use heuristics? What is the advantage and
disadvantage to use heuristics?
People use heuristics as decision-making shortcuts, which have evolutionary advantages because they simplify the decision-making process and save time and resources. The disadvantage is that heuristics often make sense but falter when used outside of their natural domain.
- What is the difference of risk and ambiguity? What is
ambiguity aversion? What is Ellsberg Paradox? Why is it a
paradox?
Risk involves situations with known probabilities, while ambiguity involves situations with unknown probabilities. Ambiguity aversion is the preference for known risks over unknown ones. The Ellsberg Paradox demonstrates ambiguity aversion, where people prefer a gamble with known probabilities over one with unknown probabilities, violating the principle of expected utility theory. It’s a paradox because it shows rational actors deviating from the expected utility theory due to the presence of ambiguity
- What is endowment effect and what is status quo bias? What
is the possible heuristics for both biases?
The endowment effect is the tendency to value an owned object more highly than a non-owned object. Status quo bias is the preference to keep things in their current state rather than change. A possible heuristic for both biases could be a desire to avoid loss or change, influencing individuals to overvalue their current possessions or situation
- Give examples of home bias in investment. Give potential
rational and behavioral explanations. What is the potential
heuristics underlying the behavioral explanations?
Home bias refers to investors’ preference for domestic over foreign assets. Rational explanations include informational advantages and transaction costs( institutnal restrcitions such as capital movement restrictions, diffenrential trading costs, differential tax rates), while behavioral explanations involve familiarity and excessive optimism. The underlying heuristic might be a preference for the familiar, leading to a perceived lower risk and overoptimism about domestic investments.
Financial behavior stemming from familiarity: home bias, distance & culture, investing in your employer or brands you know
- What is conjunction fallacy? Using Linda example to explain
the underlying heuristics of conjunction fallacy.
The conjunction fallacy occurs when people incorrectly judge the conjunction of two events to be more probable than one of the events in isolation. In the Linda example, people mistakenly believe it’s more likely for Linda to be a bank teller and active in the feminist movement than merely being a bank teller, due to the representativeness heuristic
