Article

Bleed or Blowup? Why Do We Prefer Asymmetric Payoffs?

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Abstract

This paper surveys the behavioral literature in search of possible explanations for the preference for negative skewness on the part of economic agents. 1) We relate the mathematical properties of skewness to biases in inductive inference and suggest further research needed for the conditions of the real world in which agents are not presented the probabilities of rare events but need to derive them themselves. 2) We link the acceptance of the occasional large loss for a steady small profit (as opposed to the opposite payoff) to elements of prospect theory and the research on well-being and the hedonic treadmill effects.

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... The metaphor Black Swan is historically attributed to the difficulty in epistemology called Hume's Problem of Induction 3 , of the complication that lie in deriving general rules from observed facts –and from those facts only (see the general discussion in Taleb and Pilpel, 2004). How many white swans does one need to observe before inferring that all swans are white and that there are no black swans? ...
... This points to a quite severe flaw in human's native statistical inference machinery: people take the last few observations as descriptive of the general distribution (since these are readily available) and, accordingly, are very quick at making general rules. This author discussed (Taleb, 2004) how rare events are even more exacerbated by the effect: if an event deemed to happen every 5 years does not happen in a year, agents will be likely to believe that its incidence is greatly reduced (since the recent past is more easily retrieved in our memory). ...
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... 39: Individual response to media promoting bulk buying 1. 40: Individual response to media promoting bulk buying 2. ...
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Analysis of decision making under risk has been dominated by expected utility theory, which generally accounts for people's actions. Presents a critique of expected utility theory as a descriptive model of decision making under risk, and argues that common forms of utility theory are not adequate, and proposes an alternative theory of choice under risk called prospect theory. In expected utility theory, utilities of outcomes are weighted by their probabilities. Considers results of responses to various hypothetical decision situations under risk and shows results that violate the tenets of expected utility theory. People overweight outcomes considered certain, relative to outcomes that are merely probable, a situation called the "certainty effect." This effect contributes to risk aversion in choices involving sure gains, and to risk seeking in choices involving sure losses. In choices where gains are replaced by losses, the pattern is called the "reflection effect." People discard components shared by all prospects under consideration, a tendency called the "isolation effect." Also shows that in choice situations, preferences may be altered by different representations of probabilities. Develops an alternative theory of individual decision making under risk, called prospect theory, developed for simple prospects with monetary outcomes and stated probabilities, in which value is given to gains and losses (i.e., changes in wealth or welfare) rather than to final assets, and probabilities are replaced by decision weights. The theory has two phases. The editing phase organizes and reformulates the options to simplify later evaluation and choice. The edited prospects are evaluated and the highest value prospect chosen. Discusses and models this theory, and offers directions for extending prospect theory are offered. (TNM)
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Investors are keenly interested in financial reports of earnings because earnings provide important information for investment decisions. Thus, executives who are monitored by investors and directors face strong incentives to manage earnings. We introduce consideration of behavioural/institutional thresholds for earnings in this mix of incentives and governance. A model illustrates how thresholds induce specific types of earnings management. Empirical explorations find clear support for earnings management to exceed each of the three thresholds that we consider: positive profits, sustain-recent-performance, and meet-market-expectations. The thresholds are hierarchically ranked. The future performance of firms that possibly boost earnings to just cross a threshold appears to be poorer than that of less suspect control groups.
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Many people believe in the "Law of Small Numbers," exaggerating the degree to which a small sample resembles the population from which it is drawn. To model this, I assume that a person exaggerates the likelihood that a short sequence of i.i.d. signals resembles the long-run rate at which those signals are generated. Such a person believes in the "gambler's fallacy", thinking early draws of one signal increase the odds of next drawing other signals. When uncertain about the rate, the person over-infers from short sequences of signals, and is prone to think the rate is more extreme than it is. When the person makes inferences about the frequency at which rates are generated by different sources --- such as the distribution of talent among financial analysts --- based on few observations from each source, he tends to exaggerate how much variance there is in the rates. Hence, the model predicts that people may pay for financial advice from "experts" whose expertise is entirely ...
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This article presents some new results on an unexplored dataset on hedge fund performance. The results indicate that hedge funds follow strategies that are dramatically different from mutual funds, and support the claim that these strategies are highly dynamic. The article finds five dominant investment styles in hedge funds, whichwhenadded to Sharpe's (1992) asset class factor model can provide an integrated framework for style analysis of both buy-and-hold and dynamic trading strategies
CTAs and Hedge Funds: A Marriage Made in Heaven
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Jack: Straight From the Gut
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Hedonic Relativism And Planning The Good Society
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Welsh, J. Jack: Straight From the Gut. New York: Warner Books, 2001.