Larson, List, and Metcalfe (2016) on Myopic Loss Aversion and the Equity Premium Puzzle

Francis Larson, John A. List, and Robert D. Metcalfe, “Can Myopic Loss Aversion Explain the Equity Premium Puzzle? Evidence from a Natural Field Experiment with Professional Traders.” August 31, 2016; available here.

• The puzzle: the real return on US equities is about 8% per annum, versus about 1% for riskless assets. This spread cannot easily be explained as a risk premium. 

• One hypothesis: traders display myopic loss aversion (MLA), and hence the frequent downticks (short-term declines in asset value) are psychologically costly – people will only put up with these costs if there is an offsetting premium in the monetary return. If MLA can explain the equity premium puzzle, then it must be present in the “marginal” trader. 

• Laboratory experiments have found that myopic loss aversion is common. The standard design involves varying the rate at which price information is delivered to traders. Those who receive information at high frequency are exposed to more revelations of downticks, and hence, if they display MLA, they will underinvest in the risky asset, the one that is subject to lots of downticks. 

• The Larson, List, and Metcalfe paper employs a (natural?) field experiment, where traders do not know they are taking part in an experiment; they think they are beta-testing a new online trading platform. 

• The traders' recompense is to be paid eventually in-kind based on the profits that they accrue during their two weeks of testing. They can “buy” a risky asset whose return is tied (in a not-fully-obvious way) to the US dollar exchange rate. The tying is such as to bias the return to the asset to be positive. 

• The experiment reveals MLA – traders who are given infrequent (once per 4 hours) price updates keep more of their stake in the risky asset, and earn considerably more, than those traders who receive second-by-second updates. 

• Traders tend to desire more frequent price updates, but perhaps that information degrades their performance. 

• Since both the Frequent (n=73) and Infrequent (n=78) groups of traders can trade at any time, this experiment avoids a confounding feature of past laboratory experiments, that both information and trade opportunities are altered among conditions.

Viscusi and Gayer (2015) on Reasons to Distrust Government Nudges

W. Kip Viscusi and Ted Gayer, “Behavioral Public Choice: The Behavioral Paradox of Government Policy.” Harvard Journal of Law & Public Policy 38(3): 973-1007, 2015 [pdf].

• Behavioral departures from full rationality are often used as justifications for government interventions in markets. But the resulting government policies can institutionalize, not rectify, the rationality shortfalls.

• Regulators themselves possess rationality shortfalls, and there are features of the environment in which regulators operate that push them away from pursuing first-best policies.

• If the median voter possesses biases, then a democratic government is likely to share those biases.

• Less-than-rational individuals tend to bear the costs of their errors themselves – not so with regulators. Further, individuals might have enhanced incentives (relative to bureaucrats) to acquire relevant information. Regulators, like all of us, can be overconfident in their abilities.

• Can we trust the claims that people are less-than-rational, or at least the universality of the claims? People are heterogeneous, and what looks like a mistake might reflect specific, reasonable preferences.

• Many consumer durables now have energy efficiency mandates, justified by internalities. But the energy-efficiency misjudgment is far from a proven problem. The claims of energy savings tend to be engineering-based, unavailable in practice, while individual circumstances can rationalize seemingly myopic choices.

• We could be more confident in an even-handed use of behavioral economics if a lot of pre-existing mandates were being replaced by non-coercive nudges. But instead, we see behavioral economics being used to tighten regulation, not to loosen it. Notice that the less-than-complete (narrow) self-interest that behavioralists often emphasize implies that even externalities might be internalized without government policy.

• The EPA instituted a fuel economy labelling requirement that seems intended to remedy all the problems that their later efficiency mandates also targets – don’t they trust their own labelling regulation?

• In dealing with health and safety risks, government does not seem to be more rational than individuals. In practice, worst-case scenarios are over-weighted in regulatory policy; EPA methodology leads to cascading of conservative estimates so that extremely low-likelihood problems can dominate policy. Further, the number of people exposed to a risk, which should be central in formulating policy, is ignored.

• Increases in risk are a sort of loss, and loss aversion kicks in – in the form of alarmist regulatory responses to ebola, terrorism, etc.

• The FDA fears errors of commission much more than errors of omission. [Nonetheless, the evidence base is weak – look how often risks are revealed only after approval; then there are off-label uses, which are quite legal, despite not having been tested in the usual sorts of controlled trials.]

• If organic veggies carry less risk than non-organic vegetables, but they cost more, it could still be better health-wise for people to eat more, non-organic veggies.

• For people to accept a small increase in risk often involves a payment some six times larger than they would pay for the same reduction in risk – a reflection of loss aversion. The “first, do no harm” principle leads to a similar effect in policy. It is often hard to identify victims of the FDA’s failure to approve a useful drug.

• Agencies can have tunnel vision, treating their issue in isolation. In OSHA, for example, regulators are not even allowed to look at the costs of fixing a hazard. One result: costs per life saved vary widely across domains, in ways that seem to be far from optimal.

Pope and Schweitzer (2011) on Tiger Woods and Persistent Bias

Devin G. Pope and Maurice E. Schweitzer, “Is Tiger Woods Loss Averse? Persistent Bias in the Face of Experience, Competition, and High Stakes.” American Economic Review 101: 129-157, February 2011.

• The notion of a reference point is central to prospect theory, but how can reference points be identified? In the game of golf, the idea of “par” provides a sort of natural reference point. 

• Prospect theory suggests that people view the outcomes of risky decisions not in overall terms, but as gains or losses relative to their reference point. To perform worse than par (a bogey or double bogey, say), is a loss relative to the reference point of par. To perform better than par (an eagle or birdie, say) is a gain relative to the reference point. 

• Prospect theory suggests that people are loss averse, being more concerned with negative departures from the reference point than with “equivalent” upward departures. Missing a putt for par will result in a loss (relative to the reference point), whereas missing a putt for birdie will still, in itself, not cause a loss. 

• Imagine two otherwise identical putts, one for birdie and one for par. In terms of monetary payoffs, both are identical for a given golfer – but they are not identical in terms of the gains/losses coding. Professional golfers perform better at such putts when they are for par than when they are for birdie. That is, the disutility associated with being on the loss side of the ledger seems to induce improved performance from golfers. A golfer who performed as well on birdie putts as he or she did on identical par putts would earn tens, even hundreds of thousands of dollars more per year. 

• Professional golfers appear to be loss averse as opposed to “fully rational,” even though they are experienced actors in a highly competitive setting, and where the monetary stakes associated with departures from rationality are quite significant.

Loewenstein, John, and Volpp (2013) on Leveraging Behavioral Biases to Help People

George Loewenstein, Leslie John, and Kevin G. Volpp, “Using Decision Errors to Help People Help Themselves.” Chapter 21, pages 361-379, in The Behavioral Foundations of Public Policy, Eldar Shafir, editor, Princeton: Princeton University Press, 2013.

• The oddly named “Theory of the Second Best” indicates that if there are some number n of conditions that must hold for things to be fully optimal (first best), then that is no reason to believe that moving from n-2 of those conditions holding to n-1 of the conditions holding represents an improvement. Perhaps your “first best” is to go to the cinema with your special friend to watch a touching romantic comedy. But if your special friend is not available (or perhaps has found someone new), then going to a romantic comedy might not be an improvement over the status quo of wallowing at home.

• Loewenstein, John, and Volpp apply the notion of the second best to fight behavioral fire with behavioral fire: harnessing departures from rationality to counteract other departures from rationality. Maybe overoptimism can be used to cancel out excessive risk aversion? 

• Asymmetric paternalism is an intervention that helps “irrational” people make better decisions, without imposing in a serious way upon the decisions of rational people. 

• The self-serving fairness bias: what favors me is fair. This bias can prevent the settlement of disputes between two parties. It can be used to promote a settlement, however, because both parties might be willing to trust a “neutral” mediator who can impose a settlement. 

• The stickiness of default options and the attractiveness of lotteries are two biases that can be used to promote weight loss, exercise, medical compliance, public transport use, and charitable contributions. 

• Lottery prizes are good motivators thanks in part to the overweighting of small probabilities. A daily lottery that lets you know if you won or not, but only pays if you were in compliance with the desired behavior on the day you won, also adds anticipated regret into the mix. 

• Some commercial entities (e.g. casinos) have significant pecuniary incentives to appeal to our less-than-rational impulses. But some firms, such as health insurers or employers who gain from our better compliance with medical protocols, have monetary incentives to make our decision making more “rational.” 

• Loewenstein, John, and Volpp note a number of biases that many people seem to display in their decisionmaking. These biases include narrow bracketing; the hot-cold empathy gap; projection bias; and present bias. 

• “Narrow bracketing” occurs when decisions are examined in isolation (perhaps as potential changes from the status quo) rather than holistically. 

• The “hot-cold empathy gap” refers to our inability to predict how we will behave in the “hot” state (perhaps when we are very hungry or angry) when we are examining our behavior while in the “cold” state. 

• “Projection bias” is the idea that people predict that their future preferences will be pretty much the same as their current preferences. But there might be hedonic adaptation, or a change in visceral factors. Projection is one explanation underlying the advice not to go grocery shopping on an empty stomach. 

• People save too little not because the rate of return to savings is too low, but (in part?) because of a “present bias” or an interest in instant gratification. The “Save More Tomorrow” plan allows people to (semi-)commit to savings increases at a later date, and this program has been quite successful in spurring savings.

• Is it distasteful or unethical to take advantage of common decision errors for paternalistic purposes?

Rabin and Thaler (2001) on Risk Aversion and the Failures of Expected Utility

Matthew Rabin and Richard H. Thaler, “Risk Aversion,” Journal of Economic Perspectives 15(1): 219-232, Winter 2001.

·  In the expected utility (EU) model, risk aversion is equivalent to diminishing marginal utility of income.

·  Any meaningful risk aversion over small stakes is inconsistent with EU maximization, as it requires a crazy unwillingness to take on risk at larger stakes. In other words, EU maximizers must be effectively risk neutral for small stakes, such as those in laboratory experiments. Nonetheless, people display risk aversion at small stakes.

·  Extended warranties and rental car insurance are purchased by many people, though the small stakes (relative to lifetime wealth) and high prices involved imply that they should be unattractive to expected utility maximizers.

·  Small-scale risk averse behavior is consistent with loss aversion, where the status quo is the reference point, and with mental accounting (narrow bracketing), a failure to look at the situation in the bigger picture.

·  Even the money pump argument offers more support for loss aversion and narrow bracketing than for expected utility maximization, as people are not reliably turned into money pumps. They are more likely to purchase those ill-advised warranties, for instance, when the warranties are tied to the purchase of the good itself, thereby promoting an isolated view of the transaction; for most decisions, consumers will not be so misled. An expected utility maximizer who bought such a warranty, however, would then necessarily agree to all sorts of ridiculous purchases.

·  The rate-of-return on stocks (as opposed to bonds, say) seems to be excessive, even though there should be some premium for holding stocks because stocks are riskier than bonds. This “equity premium puzzle” might be due to loss aversion and narrow bracketing. The day-to-day fluctuations in stock prices cause many short-term losses for shareholders. The equity premium comes from the fact that loss-averse investors require compensation to put up with all of the short term (mental accounting) losses.