Shane Legg on prospect theory and computational finance
People are not rational expected utility maximisers. When we have to make decisions, all sorts of cognitive biases and distortions come into play. Seminal work in this area was done by Kahneman and Tversky. They produced a model of human decision making known as prospect theory, work that Kahneman later won a Noble prize …
… I looked at these investors and thought, “Hey, they’re just like reinforcement learning agents. No big deal. If I want to know what investors with probability weighting and a curved value function do, I can just brute force compute their optimal policy by writing down their Bellman equation and using dynamic programming. Easy!” It was a mystery to me why, seemingly, nobody else was doing that. So off I went to build software to do just this, starting with a simple Merton model…
… When we fired up my simulator and gave this distribution to an investor that had probability weighting: the investor took one look at that scary negative tail and didn’t want to invest in the stock. This is exactly what the model should predict. In short, we took realistic stock returns, and presented this to an investor with a realistic decision making process complete with a bunch of parameters that have been empirically estimated by others in previous work, and what we got out the other end was realistic investor behaviour!
Read the whole article here at Vetta Project.
This is interesting, but (as far as I know) a much better explanation as to why most people don’t own stock is that they don’t actually bother researching how to invest or spend much cognitive effort on investing.
Perhaps Napoleon’s old statement needs a corollary: “Never attribute to a complicated model of behaviour contingent on the interconnection of numerous noisy empirical estimates that which is adequately explained by incompetence.”
Sure, there will be a great many factors at work here in the real world that our model does not include. The challenge is to come up with a manageable collection of principles that can be observed and measured across a wide range of situations and that appears to explain the observed behaviour. For this purpose “can’t be bothered” isn’t a very useful principle. What we really want to know is why they can’t be bothered.
For example, I know people who can be bothered going to a specific shop and queueing in line every week to get a lottery ticket, and then scheduling time to watch the draw on television. It would be a lot less total effort over the years if they went into their internet banking and transfered a few thousand dollars into an investment fund that their bank offers. Plus their expected return would be positive rather than negative. Even if you point this out to them, they probably still won’t do it. Why is it then that they can’t be bothered doing this, but they can be bothered buying lottery tickets? One potential explanation provided by prospect theory is probability weighting: the negative tail on stock returns gets over weighted, as does the chance of winning the lottery. No doubt you can come up with other hypotheses about what is going on.
I’ll also add, that while this work is a bit different to things usually covered here, it is perhaps interesting for some people to see an attempt to incorporate some of these ideas of cognitive biases into a formal mathematical model of behaviour—in this case the behaviour of investors.
I was thinking about the same. The question is, how much research must you do in order for stock investing to become profitable comparing to other ways of investing? There is also the question of fees to pay, the less you invest, the more the fees weigh in.
Fees are small. If you play the lottery the way most people do—a few quid a week—you spend maybe £200 a year on it. You could invest this in the markets and do well.
I know, because I did this myself. I invested £500 in the stock market on 2003, and 9 months ago I withdrew £850.
That seems to be far above the average expected return over 9 months for any random stock. Research accounts for the difference between your success and a random selection? You may be giving overly optimistic advice by generalizing from a single experience.
Edit: Pardon. I misread.
Wouldn’t that be 2003-2008, i.e., five years?
That’s about 11.2% annual return, if I’m mathing correctly this early in the morning.
Correct. Actually more like an 11.1% annual return, but yes. This is 2% above the expected long-term rate of return for stocks of about 9%.
I should add, though, that when I invested, I could have invested anywhere between £0 and £10,000. I chose £500 because I was young and frightened of the “risks” of the market.
Had I invested all £10k, I would now be the proud owner of about £18,000.
Depends on what you bought. More than a few stocks had the last few years of growth wiped off them last year, and that includes many well hedged managed funds. Your youthful assessment of the risks was perhaps better than you give it credit for.
What would the original investment be worth right now had you not cashed it in?
I think that Bernatzi & Thaler (1995) were the first to do an analysis of this sort (using the results of behavioral decision making research to explain why people didn’t buy stocks), although this new paper seems to include more of the features of prospect theory. Bernatzi & Thaler’s abstract: