Read an interesting piece in the WSJ today about how <a href="http://online.wsj.com/article/SB119188420773652765.html?mod=yahoo_itp&ru=yahoo">waiting affects decision making</a>: From the article:<p class="times"></p><p class="times"></p><blockquote><p class="times">Waiting drives some of us to make dumb decisions. In a study conducted by Gregory Berns, an associate professor of psychiatry and behavioral sciences at Emory University, respondents were given an option of receiving an electric shock now or a lesser shock after waiting. Roughly a third opted for more voltage sooner.</p> <p class="times">"The brain runs simulation of the future using the same process that simulates the experience itself," says Dr. Berns. This extreme response is what often governs bad decisions, he says. That may explain why some people, at the slightest whiff of layoffs, fire themselves.</p> Lee Miller, a former head of HR, has witnessed that "huge mistake" with a colleague who left his job rather than wait for an inevitable promotion. </blockquote>It is interesting to see how people prefer to solidify their uncertainty, even when the outcome is unfavorable. This would seem to go against the findings of of psychologists Kahneman and Tversky, who explored <a href="http://en.wikipedia.org/wiki/Prospect_theory">Prospect Theory</a> and loss aversion. This theory would indicate that people would rather wait and take the chance that they don't get laid off vs. quitting immediately. An added dimension of asymmetrical time for decision outcome is present here though. A simple thought experiment would suffice to demonstrate proof of concept: Given a decision of a certain loss of $1000, or a 40% chance of losing $2500 and 60% chance of losing nothing, Prospect theory states that most of us would choose the latter, reflecting loss-adverse (risk seeking) behavior, though the expected outcomes are the same. (Often the experiment is demonstrated with expected loss greater than the certain loss, yet people still choose the risky option). Let's rephrase the above though: How about if we change the outcome to be a certain loss of $1000 <span style="font-weight: bold;">today</span> or a 40% chance of losing $2500 and a 70% chance of losing nothing, <span style="font-weight: bold;">3 months</span> from now. Would you choose to take the loss today or wait three months for the outcome? The article would imply that many people would prefer the certain loss today. This behavior might be explained by our preference to minimize variance. If we were to optimize for Net Present Expected Value, we would choose the latter. Since both outcomes have the same expected value, but the latter has the extra element of being discounted back through time, waiting seems to be the optimal choice. Another <a href="http://davidmaister.com/articles/5/52/%20">article</a> talks about this and models it in a simple formula: Satisfaction = Experience - Expectation When we have low expectations of something but our experience is positive, such as an unexpectedly good movie, we are satisfied. However, when we have high expectations that are not met (low experience) then we are unsatisfied. The author of the article uses 'Perception' in place of 'Experience' but I'd like to distinguish the point because using Perception in this context is unclear. Expectations and experiences are in fact both 'perceived' subjectively. But I digress. This simple model might be modified to fit a negatively exponential utility curve instead: <center><a onblur="try {parent.deselectBloggerImageGracefully();} catch(e) {}" href="http://bp3.blogger.com/_lPCxpA1k1LY/RwyIltQHf1I/AAAAAAAAAAU/XYpWhZg2Z4E/s1600-h/utility.PNG"><img style="margin: 0px auto 10px; display: block; text-align: center; cursor: pointer;" src="http://bp3.blogger.com/_lPCxpA1k1LY/RwyIltQHf1I/AAAAAAAAAAU/XYpWhZg2Z4E/s320/utility.PNG" alt="" id="BLOGGER_PHOTO_ID_5119617057797144402" border="0" /></a></center> We find that this is consistent with the rate at which we discount money back to present value as well (PV = FV*e^-rt).
many people can take a hit of $1000 but a hit of $2500 could ruin their lives. "Given a decision of a certain loss of $1000, or a 40% chance of losing $2500 and 60% chance of losing nothing, Prospect theory states that most of us would choose the latter, reflecting loss-adverse (risk seeking) behavior, though the expected outcomes are the same. (Often the experiment is demonstrated with expected loss greater than the certain loss, yet people still choose the risky option)." I don't believe it. given a certain loss of 10,000 or a ten percent loss of 100,000 which would you choose. given a certain gain of 3.4million or a flip of a coin for 10 million which would you choose.
Economists have a concept called Utlility. It is the power of an article to satisfy one's needs. In your second example, for low-income or middle-income person ( with less than $1m in net worth and less than $100K perannum), the utility of a certain $3.4million is certainly worth more than the "probable" 10million with greater expectancy ($5million). So I believe a reasonable person in that situation will go for the certain figure. When I become rich like Bill Gates or Tiger Woods, it would make perfect sense to go for the $10million bet: the marginal utility of that $3.4million is next to nothing.
A certain outcome is not comparable to a chance outcome. It's irrelevant what the expectancy is as only one outcome will occur. (Assuming the outcomes are close e.g. 3.4 is close to 5). If it were 90% chance of 5M (or nothing) vs. 50% chance of 10M (or nothing) then you could make a comparison and choose the higher expectancy, but again the marginal utility does not outweigh the increased risk. I'd still go for the 90% option, thanks. BUT as soon as one of the options is certain, there is no reason to take any risk at all. Does that make sense to anyone?
From OP post 1 "It is interesting to see how people prefer to solidify their uncertainty, even when the outcome is unfavorable. This would seem to go against the findings of of psychologists Kahneman and Tversky, who explored Prospect Theory and loss aversion. This theory would indicate that people would rather wait and take the chance that they don't get laid off vs. quitting immediately. An added dimension of asymmetrical time for decision outcome is present here though." let's apply to trading. some traders hold onto their losers with the expectation they will turn profitable. some traders close their position at the slightest loss without waiting for a profit to come.
It makes a lot of sense, but at the same time you can compare certain vs uncertain outcomes. would you take a safe 1 million over a 50% chance for 5 million? What about 10million? Does it change when the numbers are smaller? What about a certain 10k vs a 50% chance for 50k? What if we did it with $1 and $5? I imagine that would change your answer. They are comparable. Everyones answers fit them the best personally. A persons marginal utility of the extra money certainly factors in. No one answer fits all.