Sunday, June 09, 2013

Kahneman Fast and Loose

There's a short Danny Kahneman interview at the Daily Beast here.  He notes why your best friends may not be your best advisors:
Friends are sometimes a big help when they share your feelings. In the context of decisions, the friends who will serve you best are those who understand your feelings but are not overly impressed by them. 
 That's the Kahneman I love to read, profound and interesting. But then he follows with this sentence:
For example, one important source of bad decisions is loss aversion, by which we put far more weight on what we may lose than on what we may gain. 
I don't see loss aversion as being nearly as prevalent as lottery-loving: that is, picking things with small probabilities of big gains, as opposed to avoiding things with potentially large losses.  Most really bad investments, those with the lowest expected returns, are things with large potential losses (lottery tickets, horse races, highly volatile stocks, options, penny stocks, etc.)  This means people don't avoid them too much, rather, they prefer them too much.

But that's only one class of bad investments with large losses.  Then there's picking up pennies in front of a steam roller, the kind of trade Kahneman's good friend Nassim Taleb argues is too common, where one basically sells insurance or options too cheap, making money most of the time but then occasionally blowing up and moving on to the next sucker.  Kahneman seems highly respectful of Taleb's work, and neither try and reconcile these ideas, even though they are really at the top for both.  That makes them more like interesting magazine writers (eg, Carl Zimmer, John Horgan) than scientists.

Loss aversion in practice is a curiosity, not common in its domain relative to riffs on its opposite.  I think people who love quoting him merely because once you allow irrationality in equilibrium, you are no longer constrained, and Kahneman gives one the authority to do this.  So, as much as I enjoy many things he says, I'd say he has been an enabler of sloppy thinking, net net.


Steven said...

Note that in a world of limited information (such as the world we live in), at least some loss aversion is actually rational. In particular, suppose I'm living a comfortable life making $100k per year and saving 10% of it, and face a gamble that would give me a chance of either making $150k per year or $50k per year. Analyzing that under a model of full information and perfect liquidity ignores the fact that if my income is halved, I have to learn how to live on $50k per year, which I may well not know how to do. I may have to move into a smaller place, possibly selling my house more quickly than would give me a reasonable price, and either pay movers or spend a lot of my time moving things, and so forth.

I don't think that necessarily explains all of loss aversion, and I'm not sure I can offer a rational explanation for buying lottery tickets, but I do think the gap between the traditional models and reality has more to do with the assumptions of full information and free logistics and less to do with the assumption of perfect rationality than most people appreciate. This might be an effect of my time at Rochester.

Piyo said...

Could loss-aversion play a non-trivial role in wage stickiness? *If* so, then that would certainly elevate its real-world importance.

Arrrrgh... said...

Both loss aversion and lottery tickets can be confirmed by lab experiments, field studies, surveys, purchase behavior, etc. In some ways they're both just "curiosities".

But why do lottery tickets persist in equilibrium asset pricing where loss aversion does not?