As hinted in an earlier post, human beings are not exactly behaving in a consistent and measurable way when it comes to acting upon risk. I usually consider evolution to be rational and therefore people to be rational in some paleolithic sense but sometimes I wonder. In a book published only (?) on the Internet, Aswath Damodaran summarized a number of interesting facts about our behavior when exposed to risk:
- Individuals are generally risk averse, i.e., they don’t act on expected returns only, and are more so when the stakes are large than when they are small.
- There are big differences in risk aversion across the population and significant differences across sub-groups.
- Risk aversion for a population varies with time.
- Individuals are far more affected by losses than equivalent gains.
- Individuals become more risk averse when they get frequent feedback on the results of their activity.
- The choices that people make (and the risk aversion they manifest) when presented with risky choices or gambles can depend upon how the choice is presented (framing).
- Individuals tend to be much more willing to take risks with what they consider “found money” than with money that they have earned (house money effect).
- There are two scenarios where risk aversion seems to decrease and even be replaced by risk seeking. One is when individuals are offered the chance of making an extremely large sum with a very small probability of success (long shot bias). The other is when individuals who have lost money are presented with choices that allow them to make their money back (break even effect).
- When faced with risky choices, whether in experiments or game shows, individuals often make mistakes in assessing the probabilities of outcomes, over estimating the likelihood of success, and this problem gets worse as the choices become more complex.
The reason I’m reading the book is that it gives an account of real options as a way to reasoning about project investment decisions, the theme of some earlier posts. I will return to real options later.
The book’s author at one point speculates if it wouldn’t be better to have computers make our investement decisions, given the inconsistencies of human decision makers; as it says in the lyrics of the song I.G.Y. By Donald Fagen:
A just machine to make big decisions
Programmed by fellows with compassion and vision
We’ll be clean when their work is done
We’ll be eternally free yes and eternally young