Risky risky...

I am about to toss a fair coin. If heads you win £100. If tails you lose £100.

Do you want to play this gamble?

If yes, then you are risk-preferring.

If no, then you are risk-averse.

If you are indifferent, then you are risk-neutral.

That is because the expected value of the gamble is £0 (100x0.5 + -100x0.5 = 0).

Personally I would not like this gamble, which makes me risk averse. The extent of my risk averseness would have to be revealed by considering different gambles, but as long as I am consistent in my attitude to risk an economist could call me rational.

Here are a copuple of other interesting gambles which may shed light on your attitude to risk:

I am about to toss a fair coin. If heads you win £100. If tails you lose £75. Do you want to play?

I am about to toss a fair coin. If heads you win £1000. If tails you lose £50. Do you want to play?

If you would not like to play these gambles then you highly risk averse... Personally I think I would probably play both, definitely the latter one.

Risk Intelligence - Don't Know Why

Earlier today I took a fascinating online test designed to measure risk-intelligence:

www.projectionpoint.com

It measures how well you judge your ability to estimate probabilities correctly (and only takes 5 minutes).

Guruhogg scored 76.74 - see if you can beat that!

My result

Recommended listening:
Don't Know Why by Norah Jones

You've Been Framed! - American Idiot

• You are ill in hospital. The surgeon informs you that he could operate. If successful the operation will cure you completely. He tells you that 95% of patients survive the operation.

What do you decide?

• You are ill in hospital. The surgeon informs you that he could operate. If successful the operation will cure you completely. He tells you that 5% of patients do not survive the operation.

How about now?

Standard economics has always assumed that people's preferences are stable. Thus the way in which questions are worded should not have an impact on what we prefer. Psychologists beg to differ.

Now, you're probably telling yourself that you're unaffected by the way the question is 'framed'. However, evidence shows that people are highly susceptible to framing effects.

More worryingly, evidence shows that doctors are equally susceptible to framing when faced with similar problems to the one above!

We are all to some extent irrational when it comes to framing effects. But never fear, there is an easy way to improve your rationality - simply reframe the problem and see if it changes your preference...

If told:

• 30 people die out of every 10,000 that undergo an operation

remind yourself that

• 99.7% survive

Remembering this should help you improve your decision making... Simples!

Recommended listening:
American Idiot by Green Day

Mattress Money - Hakuna Matata?

A recent BBC article highlighted the growing trend among Greeks to withdraw their money from banks and, presumably, put it under their mattresses. With confidence in their currency fading fast one can understand why the Greek populous are voting with their money, so to speak. This is an example of risk averse behaviour.

We all have different attitudes towards risk. Some are risk preferring, some risk neutral and some risk averse.

If you had the following choice, which of the two options would you choose?

• A 50% chance of getting £100
• A 100% chance of getting £40

I would hope it would be obvious that the first option has a higher expected value (0.5 times 100 is 50). Despite this, many of us (me included) would choose the certain £40. This is called risk averse behaviour. In our minds the 50% risk of getting nothing is not worth taking.

The Greeks who are withdrawing their cash from banks are exhibiting risk averse behaviour. They would clearly prefer to forgo any interest they could earn from their savings, instead making sure that whatever happens at least they have some money.

It's commonly accepted among economists that people are often relatively risk-averse, and thus good economic models account for this type of behaviour. Risk aversion is not bad, indeed, we could do with bankers taking fewer risks at the moment! The level of risk aversion will depend upon the exact situation. For example, if I had already given you £500 before giving you the above choice, you may have been more likely to take the risk (any economists out there will recognise this as the income effect).

In conclusion, mattress money is a prime example of risk aversion. I wonder, if you were Greek right now, would you be happier sleeping on your life savings or entrusting it all to the banks?

Recommended listening:
Hakuna Matata

Preference Reversal – I Need A Dollar

As we discovered last time, for traditional economics relies upon economic agents being consistent and thus rational. Today we will uncover a common phenomenon: preference reversal.

Let’s start with a little experiment...

You have a choice. There are two options of differing payoff and probability. Imagine that you, the subject, will get to keep any payoff you get. I, the experimenter, will pick a ball at random from a bag (a la bingo) to decide whether you are awarded any payoff. If you choose Option A I will use a set of balls that give you a 70% chance of getting the payoff (of £24), if you choose Option B I will use a set of balls that give you a 25% chance of getting the payoff (of £80).

	Probability	Payoff
Option A	0.7	£24
Option B	0.25	£80

• If you had to choose between them, which option would you rather have?

• Now think about how much each option is worth to you: what amount of money would be of equal value as each option? (What would you deem a fair price for each option to be?)

If you’re anything like me you will have chosen Option A. You may also have valued Option A at something like £17 and Option B at around £20. 

And if you did, you were irrational. 

Why? Because you said you prefer the Option A in the straight choice, but value Option B higher. This is inconsistent. We can infer that you both prefer Option A and Option B (because you valued it at a greater sum of money). You have ‘reversed’ your preferences. This is ‘standard preference reversal’ (‘non-standard’ is where someone chooses Option B, but values Option A higher). PR is asymmetric; the overwhelming majority of preference reversals are the standard type.

If you were inconsistent, don’t worry, you are not alone. If you were consistent you are probably smug, well done. 

Preference reversal (PR) is the phenomenon where individuals change what they say they prefer, purely because the way they were asked was different. Interestingly, people change their preferences in a highly predictable, yet irrational, way. 

The psychologists Lichtenstein and Slovic (1971) first demonstrated PR using their, now famous, experiment design (as roughly replicated above). They called Option A the ‘P-bet’ and Option B the ‘$-bet’.

The first economists to take notice of PR were David Grether and Charles Plott in 1979. They set out to ‘discredit’ the psychologists findings. They failed. Badly. After testing 13 theories they were forced to conclude that PR was not caused by flawed research. My favourite of their theories include:

Theory 12: The original experiments were done on psychology students who are ‘unsophisticated subjects’.

Theory 13: The original experiments were done by psychologists ‘who have a reputation for deceiving subjects’. 

Alas, it turns out that PR is real and here to stay. We will explore the causes of PR in later blogs, but the debate is basically between economists and psychologists over whether it is inherently daft to assume that people have underlying preferences. Psychologists argue that we only ‘construct’ preferences when we face decisions, while economists argue that our preferences already exist and we just refer to them.

I will finish by giving an example of PR in the real world (controversial, I know)...

http://static.guim.co.uk/sys-images/Guardian/Pix/pictures/2012/1/31/1328027920111/high-speed-train-Eurostar-007.jpg

Imagine you own a sheep farm in the Chiltons. However, the Government wants to build a high-speed rail link right through your land. The new line can either go straight past your delightful little cottage (causing you a big headache), or it can take a longer route going through your fields (taking up more of your prime sheep farming land). The Government wants to know which route you’d prefer. They can either ask you which option you would chose in a straight choice, or they can ask you how much compensation you will demand for each option (and choose the cheapest). Governments worldwide use both methods of asking people all the time, assuming they yield the same preference. 

PR would suggest that they might not...

Recommended listening:

I Need A Dollar by Aloe Blacc