On attitudes to risk

There’s a nice juxtaposition between two of the biggest stories of recent days: retail investors piling into Game Stop; and the reluctance of ethnic minorities to take Covid vaccines and the slowness of the European Medicines Agency to approve them.

The thing is that these are all stories about extreme attitudes to risk. Small investors buying a dodgy company looks like risk-loving behaviour, whilst refusing to approve or take the vaccine looks like high risk aversion.

What explains such a big contrast?

Conventional neoclassical economics has no answer. It sees them as mere differences in tastes, which it regards as exogenous.

This won’t do. It’s just shrugging your shoulders. Not that this is the only problem they have. As Thaler and Rabin have shown, the standard approach to attitudes to risk predicts that we reject even good bets. And in fact, it struggles to explain such a basic fact as why people both gamble and buy insurance.

There is, however, a much better way of thinking about people’s attitudes to risk, inspired by a paper (pdf) by Michael Woodford and colleagues.

When we think about a risk, such as a 50-50 chance of winning or losing £100, it’s natural to ask: how would I feel if I lost or won £100? We try to translate expected monetary values into mental states. But this translation, says Woodford, is prone to “noisy coding” and yields answers that are only “approximate”. Faced with the same gambles, therefore, willingness to bet can vary from person to person not because of differences in the marginal utility of wealth, but because of differences in coding. And in fact, the same person’s willingness to bet will vary from context to context because the coding varies.

This might seem trivial, but it explains a lot. For example:

 - Why we gamble and buy insurance. The questions “how would I feel if my house burnt down?” and “how would I feel if I lost £1000 in the casino?” have answers which are coded very differently. It’s not that we have different marginal utilities over wealth as Friedman and Savage claimed (pdf). It’s that these are utterly different questions.

 - Why we pay more to cut risk from (say) 10% to zero than from (say) 30% to 20%. It’s difficult to translate a 20% chance into mental states, so we still face uncertainty. A zero probability, however, eliminates this uncertainty. And we’re willing to pay for that.

 - Why some people back longshots or speculative stocks despite their poor prospects. In terms of expected value, a 1% chance of a £1000 win is worse than a 15% chance of a £100 win. Some people, though, code it differently. They figure that £1000 will do more than ten times as much good for them as £100 – for example by allowing them to break even after past losses or to pay off their debts. (This is of course compatible with prospect theory).

 - Why some are reluctant to take the vaccine. Mere talk of the issue raises the subject of death and so colours the coding: “the jab could kill me”. This is especially true for people who distrust authority.

 - Why our attitudes to risk aren’t always accurate as a guide to future utility. Just before the 2008 crash, Christoph Merkle asked UK equity investors how they’d feel if they lost a lot. He then surveyed them after they had actually lost money. And he found they were less miserable than they expected to be. This is consistent with noisy coding. In early 2008, it was difficult to translate a 20% loss into a mental state. By the end of the year this difficulty had disappeared. (I suspect people in early 2008 under-estimated the extent to which they’d be comforted by the knowledge that everybody else was in the same boat.)

 - Why bubbles sometimes form. One driver of them is a shift in coding. Investors change from “this stock could lose me money” to “if I don’t buy I’ll miss out.” And – in Game Stop’s case – to “my buying will sock it to hedge funds.” In this way, investors anaesthetize themselves against the possibility of loss.

 - Why people more capable of cognitive reflection (pdf) tend to take more risks. It’s because they are better at coding expected monetary values into mental states, and so face less uncertainty.

What we have here, though, is not merely a story about attitudes to risk. It’s also a story about how some of the presumptions of neoclassical economics are doubtful. It presumes that our preferences can be described by a simple equation describing marginal utility. But this needn’t be so. Our psychology is more interesting than that. It also presumes that preferences are just given. But in fact we can intelligently ask how they are formed. For example, past losses can make us more risk-seeking to get even, and good stories can encourage us to take risk. (A general failing of neoclassical economics is its incuriosity about genealogy). It also presumes that preferences are a guide to our future happiness. But as Merkle has shown, this is not the case: where there is noisy (or plain bad) coding, our preferences need not fulfil our interests.

What looks like an arcane area of economics is therefore central not only to how we behave in important respects but also to some of the shortcomings of neoclassical economics.

Comments

[Westering11]

I love this whole speculation. I would like to take it further and say that what a human is is not stability, balance and some constant struggle for wholeness and happiness. I claim we don't want happiness and that catastrophe is what animates us and through our constant struggle to know what 'reality' is and failing we come to subjectivity. And that what makes us human and not animal is that an animal will not ruin a good thing for an idea ... which is precisely what the definition of a human is. We get stuck on an idea and our brain, like a virus (Hitchens said it I believe) can kill our bodies for it. Like falling in love. None of this is a critique but merely a supplement to a tremendously important discussion ! Thank you.

[rsm]

The failure of neoclassical utility models means markets don't provably discover prices efficiently. That means inflation is psychological, too. Black said all this in 1986 in "Noise", but he was ignored.

If we get rid of neoclassical inflation theories, we can treat inflation with Cost of Living Adjustments, insurance (inflation swaps), and Treasury Inflation Protected Securities. The Fed can pay inflation as interest on Fed basic income deposit accounts (to encourage saving as inflation rises). The Fed can also buy and sell inflation swaps to set inflation expectations (breakevens) where they want them.

Traditional economics is holding us back. This GME episode should dispel any lingering notion that markets discover prices efficiently. And once the Efficient Market Hypothesis goes, so do the traditional ways of fighting inflation by tightening money ...

[phoenix_rising]

"Just before the 2008 crash, Christoph Merkle asked UK equity investors how they’d feel if they lost a lot. He then surveyed them after they had actually lost money. And he found they were less miserable than they expected to be."

These are two different questions, i.e., how do you feel about losing a lot versus how do you feel about losing a lot when everyone else is losing a lot.

We are after all creatures of relativity. Social hierarchy and all that.

Apples and oranges.

[MB]

I think the difference between downside and upside risk is a big part of the explanation here too. Part of the reason lots of people invest in speculative stocks is that, although they may post poor returns in the aggregate over time, they can post staggering returns individually in short spaces of time. So, for those prepared to do their research properly and invest early, they're a far more logical choice than defensive stocks, particularly if you don't have the luxury of a pre-existing pile of (inherited) cash or lots of time to grow one in order to generate decent gains with less risk.

I'm currently sitting on one such stock in the mining sector that was over 2000% up from my buy-in point recently: the impact of gains like this compared to both trackers and funds (not to mention savings accounts!) is like night and day. You only need one of half a dozen speculative stocks to pay off and you've both covered your losses and dramatically changed your life for the better to an extent that just isn't possible otherwise.

I attribute the risks I'm prepared to take in investing to two things: a) growing up poor in a working-class family in a cold council house, and never wanting to go back there; and b) a keen appreciation of the difference between downside and upside risk. Put simply: in terms of the impact on my life, I can afford to lose a few thousand pounds far more than I can afford to miss out on the possibility of hundreds of thousands.

The frustrating thing is that nobody tells working-class kids this when they're at school, so they spend their lives saving 5% of their pay (if they're lucky not to have it all extracted by the rentiers that employ and house them) and putting it in savings accounts paying 0.5% interest, terrified of doing anything more "risky" in case they lose what little they have, and totally oblivious to the fact that they're missing out on upsides every day. Rich kids, by contrast, know instinctively that the name of the game is to build a sizeable capital pile, maintain it, and then spend forever skimming a little bit of the gains each year. But until you build the pile, you're locked out of the game. It makes me so angry.

[Nanikore]

It's a basic lack of interest in how things really work. It is a fundamental lack of curiosity. You might think I'm joking, but when I was in the economics profession if someone put a real case for how things really work, they were dismissed with statements like "yes, but that can't be modelled". A Nobel prize in economics will not be awarded for good research or important new findings. They will be awarded for how they might get that (however silly) into the neo-classical framework. There is also a lack of interest in anything that can't be measured. Lars Syll had a good quote up by Adorno about how numbers are preferred by the bourgeois to real argument and sometimes intentionally, distract from it. I am a firm believer that Britain should have stayed in the EU, but they made a big mistake when instead of saying the costs (economic and other) are uncertain, but likely to be large and long term , came up with year by year forecasts to the exact pound per household, and based on all sorts of assumptions (all of which together are unlikely to hold). The political cost is for all to see. Little effort was made to really explain to people the geopolitical and economic reasons why Britain must maintain a central position in European decision making. Obama tried, but these were not properly reported.

[Jim]

I think the is a lot hanging on 'A general failing of neoclassical economics is its incuriosity about genealogy'.

Generally the adage 'clogs to clogs in three generations' seems to apply - but not to the very wealthy. A mechanism preventing the feckless squandering seems to have some effect - for a while. Then we often see that 'brainy' parents do not often produce brainy children. But we also see that brains are far from the only factor. A rat-like cunning seems very useful and a plodding determination is also good. There seems a financial hurdle that once jumped your children can be thick as mince and it does not matter.

Interestingly politics and journalism and perhaps medicine seem to run in families. Perhaps they have a natural talent or know a good racket when they see one.

We might also consider the role of the private schools. Children seem to benefit from being sent away or made to feel special. Somehow I doubt it would be all that easy to send all state school children way from home or as day pupils. Perhaps we deliberately connive to keep the wealthy wealthy through some kind of soft mollycoddling at home of ordinary kids.

Then we might ask why so few of the working class start up small businesses when immigrants seem to start with a corner shop and grow an empire from it. The trope of early marriage/partnership and finding a home seems to absorb an inordinate amount of cash and effort. Almost as if our system is designed to keep the lower orders in a new kind of slavery.

Taking a leaf out of the immigrant book, living many to one home, all pull together with a tight community seems helpful. Something of the old religious sects and early building society ethos. Bring back the Quakers and Church on Sunday...

Perhaps we can think of life as a game of snakes and ladders. All we need to do is make the snakes a bit more meritocratic and put a few more rungs on the bottom of the ladders.

[Alex]

Why we gamble and buy insurance. The questions “how would I feel if my house burnt down?” and “how would I feel if I lost £1000 in the casino?” have answers which are coded very differently //

well no, the value at risk in the first is between two and three orders of magnitude bigger than the second. you'd have to be a big gambler indeed to be able to self-insure the whole value of your home just by abstaining from gambling.

[ltr]

February 1, 2021

Coronavirus

UK

Cases   ( 3,835,783)
Deaths   ( 106,564)

Deaths per million   ( 1,565)

Germany

Cases   ( 2,232,316)
Deaths   ( 58,396)

Deaths per million   ( 696)

[ Such sadness. ]

[ltr]

Really, really good news:

https://www.nytimes.com/2021/02/03/us/astrazeneca-coronavirus-vaccine.html

February 3, 2021

The AstraZeneca vaccine is shown to drastically cut transmission of the virus.
By Marc Santora and Rebecca Robbins

The vaccine developed by the University of Oxford and AstraZeneca not only protects people from serious illness and death but also substantially slows the transmission of the virus, according to a new study — a finding that underscores the importance of mass vaccination as a path out of the pandemic....

[ltr]

February 2, 2021

Coronavirus

UK

Cases   ( 3,852,623)
Deaths   ( 108,013)

Deaths per million   ( 1,586)

Germany

Cases   ( 2,239,943)
Deaths   ( 59,386)

Deaths per million   ( 707)

[Blissex]

«nobody tells working-class kids this when they're at school, so they spend their lives saving 5% of their pay [...] in savings accounts paying 0.5% interest [...] they're missing out on upsides every day.»

MB's comment is interesting but it is totally misguided, because what works for one cannot work in the aggregate.

Consider that rather than speculating on specific stocks something with far higher and safer returns: 10-20 times leveraged speculation on residential property, where for the past 40 years there has been a gross return of 100% per year on a cash deposit, and a 50-70% net compound APR on that cash, without spending much time stock picking, and usually entirely tax-free. Residential property in the south-east has doubled in price every 7-10 years for 40 years, can be bought on 10-20 times leverage, and that's pretty much guaranteed by the government. It is the most amazing "wealth" extraction system ever devised.

Given that, the *obvious* suggestion to "working-class kids" as to "build a sizeable capital pile, maintain it, and then spend forever skimming a little bit of the gains each year" is to become BTL speculators in south-east England, rather than speculators on mining etc. stocks.

But how would work in the aggregate? Rentier paradise: if everybody in the UK became BTL speculators, everybody in the UK could stop working, and live comfortably because of having in residential property "a sizeable capital pile, maintain it, and then spend forever skimming a little bit of the gains each year".

But that cannot be: not everybody can be a BTL speculator, somebody must pay rent to keep BTL investors free from working. In practice there have to be at least 3-5 renters for every landlord.

The very same applies to "working-class kids" and "missing out on upsides every day" on the stockmarket: the amount of profit that can be made from stock speculation is not unlimited, it is a fixed size pie. Because the majority of people have to be workers to actually make all the stuff that capital gains and dividends can buy, and *obviously* those workers cannot be at the same time those that having built up "a sizeable capital pile" then "spend forever skimming a little bit of the gains each year".

That "growing up poor in a working-class family in a cold council house, and never wanting to go back there" was because worker income is "extracted by the rentiers that employ and house them". So the solution is not for everybody to become one of those stockmarket rentiers ("those that employ") or a property rentier ("and house them"), because that cannot work but for a small minority, not in the aggregate.

The real solution is is to minimize that extraction and have social insurance against becoming those who are "growing up poor in a working-class family in a cold council house".

[Blissex]

«the difference between downside and upside risk is a big part of the explanation here too.»

That is NN Taleb's winning argument, but my guess is that while our blogger obviously knows that, he is too keen on his wykehamism that attributes what seem "mistakes" to innocent cognitive biases such as flawed "attitudes to risk" and "where there is noisy (or plain bad) coding, our preferences need not fulfil our interests", rather than following material interests rationally.

"Lesson 101 in TAIL RISK mgmnt is to work backwards: FIRST, figure out exactly
what would ruin you, THEN eliminate/mitigate. It's the modus operandi of
investors s.a. Warren Buffet...all SURVIVORS."

Consider also: https://twitter.com/MKM_Abdul/status/1069180915715313664

“MKM Abdul Dec 2
My takeaway from The Incerto by @nntaleb is that most biases are optical illusions that appear when human behavior is viewed from a risk perspective and completely disappear when viewed from a ruin perspective.

Of Minds and Markets @ImagineTraffic Dec 3, 2018
Replying to @MKM_Abdul and @nntaleb
This is very interesting! Taleb's ideas have certainly had a positive impact on my trading. What is an example of a bias that disappears from a ruin perspective?

Nassim Nicholas Taleb @nntaleb Dec 3, 2018
Representativeness. It makes you paranoid. For a purpose.”