Thinking out loud on meanings
Kevin Drum in Mother Jones posits this idea:
There are several fascinating components to prospect theory, but the one that’s influenced me the most is also the simplest: when faced with a choice, people are far more motivated by loss aversion than by risk aversion.
Basically, what this means is that the emotional distress you suffer from losing, say, $100, is much greater than the emotional lift you get from winning $100. Losses always loom larger than gains.
….
The power of loss aversion is one of those insights that seems painfully obvious after someone else points it out, and once you start looking for it you can see it in all walks of life. People are simply not willing to risk losing something they already have unless they’re promised a credible chance of a much larger gain. This explains a lot of otherwise odd behaviors…
If I were a predator, sitting on a deer carcas when another deer walked stupidly close to me, my best call is to keep sitting on the carcas. I don’t have the capacity to eat both, and if I don’t stick with the carcas, I could lose it and not manage to kill the one that’s walking around.
If I’m a squirrel (watch it out there) sitting within fighting distance of my winter stash, am I best served by going off to hunt up more acorns, or sitting tight?
Most of us are not near a critical lower bound in the necessities of life. We are not like a predator limited by the size of its gut or a squirrel, who’ll starve if too much of its winter stash is pilfered. But that’s where our brains came from.
Financial theory, in its simplest form, assumes we can borrow against future income. There is a continuum of circumstances across levels of debt and savings, so that necessities are just a credit-card swipe away. Bankruptcy, not death, is the lower limit in financial theory. But that is not where our brains came from.
More than ten years ago I read an article in Forbes magazine about ‘mice being better decision makers than men’. I have it in some dusty old hard drive file on an old PC.
I was working a badly run (general rule for these things see F-22, F 35, San Antonio Class, Future Combat System etc.) military acqusition/development where overruns and lost performance suggested it better to walk away from the couple of billion that did not get that was much worth pursuing. The men looked at it as losing the sunk costs and not look at wasting the money that would go in to building and operating that dog, which was not ready to hunt. It was likely a pride thing, saving face and making decisions on the past rather than the unspent resources that would be consumed and largly not productive. Typical again for the military industrial complex where the goal is the ‘health’ of the industry of inepts’ dividends and their existing when the generals come out for jobs after they retire.
But a mouse would make the decision on the future gain, just as Samuelson said economic man should in his Econ 101 text.
Mice are not controlled by intellect, community ‘values’ and narrow focus, their instincts are to make decisions that will produce future results, survival to reproduce again.
Man is too advanced for good decision making……………………………..
and it doesn’t explain compulsive gamblers, alcoholics, or adulterers.
which means it doesn’t explain the stock market.
or kharris’ squirrel, who, unlike the leopard with his kill, does not guard his one true nut, but buries it so he can spend his time more usefully finding and burying other nuts on the theory that next winter he has a better chance of finding “enough” buried nuts to get him through than if he sat on the one nut he has and defended it from all possible theft.
i will say this about kharris theory… each of these behaviors likely has its own brain circuit and animals whose lives are more complex than squirrels or cats face a “choice.” when you look at humans you can see how some people have “chosen” one option forever and always no matter what the actual circumstances may be.
Whilst Cumulative Prospect theory (CPT) provides an explanation of gambling on longshots at actuarially unfair odds, it cannot explain why people might bet on more favoured outcomes. This paper shows that this is explicable if the degree of loss aversion experienced by the agent is reduced for small-stake gambles (as a proportion of wealth), and probability distortions are greater over losses than gains. If the utility or value function is assumed to be bounded, the degree of loss aversion assumed by Kahneman and Tversky leads to absurd predictions, reminiscent of those pointed out by Rabin (2000), of refusal to accept infinite gain bets at low probabilities. Boundedness of the value function in CPT implies that the indifference curve between expected-return and win-probability will typically exhibit both an asymptote (implying rejection of an infinite gain bet) and a minimum at low probabilities, as the shape of the value function dominates the probability weighting function. Also the high probability section of the indifference curve will exhibit a maximum. These implications are consistent with outcomes observed in gambling markets.
http://eprints.lancs.ac.uk/30535/
A theory that people value gains and losses differently and, as such, will base decisions on perceived gains rather than perceived losses. Thus, if a person were given two equal choices, one expressed in terms of possible gains and the other in possible losses, people would choose the former.
Better stated
coberly,
I do not posit a single tree. In my neck of the woods, squirrels stash nuts over a territory, and stay close to that territory as the stock of stashed nuts rises and cold weather approaches. There is a whole bunch of jostling as they all try to dig up the other guy’s nuts while guarding their own. They don’t abandon a stash to range wide. They work a narrower and narrower area as cold weather approaches.
Though, if I understand your point correctly, then I take your point. There is more than one behavioral approach to limiting risk. Squirrels have a portfolio. Cats have a gut and claws.
How does this settle with the guy whose house burned down? Could he possibly have seen more reward by forgoing the 75 bucks for insurance? I’m not arguing the morality of the fire department here. (The fire should have been put out, regardless.)
It’s a demonstration of how moral hazard can be tamped down. Throw a free rider from a moving bus, and pretty soon everybody buys a buss token.
kharris
you have watched squirrels more closely than i have. i suspected your point might be bi-focal, but i submit the squirrel strategy is essentially different from the leopard strategy. on the other hand i don’t really know. humans have a variety of strategies avialable to them, but they tend to pick a strategy and then persist in spite of what reason might tell them if they listened to reason.
We need the Pavlov’s dog model for the stock&bond markets.
The nice dog trainer feeds Spot a poison steak, then beats Spot for eating it. Then the nice dog trainer uses Spot’s good dog food and buys up on the cheap all the steak he hasn’t poisoned yet. He consumes the steak in front of poor, sickly Spot and chides Spot for not using a professional food taster. Spot develops a serious twitch.
Dan
I left Kahneman and Tversky when they were arguing that people were really bad at estimating probability. They are, but K & T seemed to me to be committing 2 fallacies… one was that some of their probability problems would challenge real mathematicians, and the other is that they overlooked factors that might influence the choice beyond the strict probabilites. Sounds here like I was not the only one who had doubts, but I never followed up on them.
Fact is some people get a thrill out of beating the odds. And you can’t beat the odds if you never bet against them.
or studies martial arts.
In my neck of the woods it is a bumper crop of acorns!
According to Robert Schenk: Sometimes moral hazard is dramatic. Fire insurance encourages arson, automobile insurance encourages accidents, and disability insurance encourages dismemberment. In a story in its December 23, 1974 issue, The Wall Street Journal reported this bizarre instance of moral hazard:
“[T]here is the macabre case of “Nub City,” a small Florida town that insurance investigators decline to identify by its real name because of continuing disputes over claims. Over 50 people in the town have suffered ‘accidents’ involving the loss of various organs and appendages, and claims of up to $300,000 have been paid out by insurers. Their investigators are positive the maimings are self-inflicted; many witnesses to the ‘accidents’ are prior claimants or relatives of the victims, and one investigator notes that ‘somehow they always shoot off parts they seem to need least.'”
Hazards include: fire, wind, water, ice and gravity. Maybe add bactteria and organisms harmful to human/animal health.
What’s moral got to do with cause casualties to property and limb?
In Rome Crassus (see the word ‘crass’ and Spartacus’ ultimate captor) ran a scam where his slaves were organized fire brigades. When there was a big fire spreading in the town he would buy up property he wanted around the fire and his slaves would put the fire out.
I am not sure he bothered with selling subscriptions to his slaves’ services. If he did it was likely to owners of properties he did not care for.
Crassus operated in the First Triumvirate which predated Julius’ permanent dictatorship by less than 3o years.
ilsm
it’s called a mast year. the clever oaks just hate it when the squirrels eat all their babies, so they go for years without making any. then one year they put out far more than the remaining population of squirrels can squirrel away. trees are smarter than squirrels.i
fairly bizarre. but i don’t have much doubt that insurance leads to high prices for body (auto) repairs, and that leads to people forced to pay high insurance costs.
of course nothing like that happens in medicine.
Financial theory, in its simplest form, assumes we can borrow against future income. There is a continuum of circumstances across levels of debt and savings, so that necessities are just a credit-card swipe away. Bankruptcy, not death, is the lower limit in financial theory. But that is not where our brains came from.
This is really a fascinating concept and I think that KHarris has made a worthwhile connection. We are, after all, animals.
I challenge the idea that people are more afraid of loss. It flies in the face of the evidence: The success of Las Vegas, the stock market, state lotteries, etc. And especially doubling down huge losses.
People are crazy gamblers not submissive losers, nursing their losses.
of course nothing like that happens in medicine. If rates didn’t rise it would lead to socialisim, or something. Seriously though, I wonder how much of the above average cost of medical care, and annual increases, are attributable to covering the uninsured? And another factor might just be that we’re indirectly subsidizing Medicare, as well? Just a thought.
Then you are gonna have a bumper crop of Lyme disease in the next year or so.
Easy to find the estimates and argue. Go ahead.
Also the fact that crime can be attributed to relatively few families and such in a community is not really unique. Research in Boston during the heyday of community based policing (90’s) found a lot of violent crime was linked to a relatively small group of people that had ties to each other, and not Mafia types.
nanute
i think you have it all backwards. the uninsured pay more because the insured have driven the prices up. and we do pay taxes for Medicare. is that what you mean by subsidizing it? or are you thinking that the high prices we pay for private insurance somehow lower the prices that providers charge Medicare patients?
maybe you have a thought here, but i can’t tell what it is.
Sandi
I think it might be important to remember we do not borrow against future income so much as we borrow someone else’s present productivity.. with the hope that it will contribute to our future increased productivity which we will, in an honest world, share with the person we borrowed from.