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April 3 - April 5, 2022
marginal propensity to consume (MPC).
There is an additional unstated assumption: namely, that wealth is fungible. In the model, it does not matter whether the wealth is held in cash, home equity, a retirement plan, or an heirloom painting passed on from a prior generation. Wealth is wealth. We know from the previous chapters on mental accounting that this assumption is no more innocuous or accurate than the assumptions about cognitive abilities and willpower.
behavioral life-cycle hypothesis. We assume that a household’s consumption in a given year will not depend just on its lifetime wealth, but also on the mental accounts in which that wealth is held.
commitment strategy: he limited his own choices to prevent self-destruction.
Self-control is, centrally, about conflict. And, like tango, it takes (at least) two to have a conflict. Maybe I needed a model with two selves.
There is a forward-looking “planner” who has good intentions and cares about the future, and a devil-may-care “doer” who lives for the present.§
Most of us realize that we have self-control problems, but we underestimate their severity.
Although I don’t think many people were foolish enough to buy another ten-pack simply for this reason, they did seem to appreciate that the resort was making an effort to be “fair,” something we will soon see can be important to keeping customers happy.
In many situations, the perceived fairness of an action depends not only on who it helps or harms, but also on how it is framed.
A shortage has developed for a popular model of automobile, and customers must now wait two months for delivery. A dealer has been selling these cars at list price. Now the dealer prices this model at $200 above list price. Acceptable 29% Unfair 71% A shortage has developed for a popular model of automobile, and customers must now wait two months for delivery. A dealer has been selling these cars at a discount of $200 below list price. Now the dealer sells this model only at list price. Acceptable 58% Unfair 42%
But firms don’t always get these things right. The fact that my MBA students think it is perfectly fine to raise the price of snow shovels after a blizzard should be a warning to all business executives that their intuitions about what seems fair to their customers and employees might need some fine-tuning.
A public good is one that everyone can consume without diminishing the consumption of anyone else, and it is impossible to exclude anyone from consuming it.
“The purely economic man is indeed close to being a social moron. Economic theory has been much preoccupied with this rational fool.”
This means that people are more likely to keep what they start with than to trade it, even when the initial allocations were done at random. The result could not be any stronger or clearer.
The endowment effect experiments show that people have a tendency to stick with what they have, at least in part because of loss aversion.
“status quo bias.”
Loss aversion and status quo bias will often work together as forces that inhibit change.
First, people have a natural tendency to search for confirming rather than disconfirming evidence,
Second, the confirmation bias can be accentuated when unwarranted assumptions make some kinds of disconfirming evidence seem unlikely,
First, he more or less invented the field of behavioral game theory, the study of how people actually play games, as opposed to standard game theory, which studies how Econs would play games if they knew that everyone else playing was also an Econ. More recently, he has been at the forefront of neuro-economics, which uses techniques such as brain imaging to learn more about how people make decisions.
If you go on a vacation, is each component of the cost of the trip (travel, hotel, meals, outings, gifts) considered a separate transaction, or are they pooled into the vacation category and evaluated together, as they would be in an all-inclusive cruise trip? The specific question that Danny and I were each pondering is: when do people get themselves into trouble by treating events one at a time, rather than as a portfolio?
narrow framing prevented innovation and experimentation, two essential ingredients in the long-term success of any organization.
In order to get managers to be willing to take risks, it is necessary to create an environment in which those managers will be rewarded for decisions that were value-maximizing ex ante, that is, with information available at the time they were made, even if they turn out to lose money ex post.
The term “equity premium” is defined as the difference in returns between equities (stocks) and some risk-free asset such as short-term government bonds.
The law of large numbers says that if you repeat some gamble enough times, the outcome will be quite close to the expected value. If you flip a coin 1,000 times, the number of heads you get will be pretty close to 500.
phenomenon “myopic loss aversion.” The only way you can ever take 100 attractive bets is by first taking the first one, and it is only thinking about the bet in isolation that fools you into turning it down. The same logic applies to investing in stocks and bonds. Recall that the equity premium puzzle asks why people would hold so many bonds if they expect the return on stocks to be 6% per year higher. Our answer was that they were taking too short-term a view of their investments. With a 6% edge in returns, over long periods of time such as twenty or thirty years, the chance of stocks doing
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As predicted by myopic loss aversion, those who saw their results more often were more cautious. Those who saw their results eight times a year only put 41% of their money into stocks, while those who saw the results just once a year invested 70% in stocks.
These experiments demonstrate that looking at the returns on your portfolio more often can make you less willing to take risk.
The implication of our analysis is that the equity premium—or the required rate of return on stocks—is so high because investors look at their portfolios too often. Whenever anyone asks me for investment advice, I tell them to buy a diversified portfolio heavily tilted toward stocks, especially if they are young, and then scrupulously avoid reading anything in the newspaper aside from the sports section. Crossword puzzles are acceptable, but watching cable financial news networks is strictly forbidden.#
The higher the wage, the less drivers worked.
Basic economics tells us that demand curves slope down and supply curves slope up. That is, the higher the wage, the more labor that is supplied. Here we were finding just the opposite result!
Well, not all drivers made this mistake. Driving a cab is a Groundhog Day–type learning experience, in which the same thing happens every day, and cab drivers appear to learn to overcome this bias over time. We discovered that if we split each of our samples in half according to how long the subjects had been cab drivers, in every case the more experienced drivers behaved more sensibly. For the most part, they drove more when wages
were higher, not lower. But of course, that makes the effect even stronger than average for the inexperienced drivers, who look very much like they have a target income level that they shoot for, and when they reach it, they head home.
“efficient market hypothesis”
The EMH has two components, which are somewhat related but are conceptually distinct.† One component is concerned with the rationality of prices; the other concerns whether it is possible to “beat the market.”
The data breakthrough occurred at the University of Chicago, where the business school got a grant of $300,000 to develop a database of stock prices going back to 1926. This launched the Center for Research in Security Prices, known as CRSP (pronounced “crisp”).
Economists sometimes call this the Groucho Marx theorem. Groucho famously said that he would never want to belong to any club that would have him as a member. The economist’s version of this joke—predictably, not as funny—is that no rational agent will want to buy a stock that some other rational agent is willing to sell.
Similarly, if everyone believed that every stock was correctly priced already—and always would be correctly priced—
there would not be very much point in trading, at least not with the intent of beating the market.
One of the simple measures that Graham advocated in order to decide whether a stock was cheap or expensive was the price/earnings ratio (P/E), the price per share divided by annual earnings per share. If the P/E ratio is high, investors are paying a lot per dollar of earnings, and implicitly, a high P/E ratio is a forecast that earnings will grow quickly to justify the current high price.
Examples of regression toward the mean can be found in every aspect of life. If a basketball player scores 50 points in a game, a personal best, it is highly likely that he will score fewer points the next game. And similarly, if he scores three points, his worst game in two years, it is almost certain that he will do better the next game. Children of seven-foot-tall basketball players are tall—but not usually as tall as that. And so forth.
If this corporate stereotyping is combined with the tendency to make forecasts that are too extreme, as in the sense of humor study, you have a situation that is ripe for mean reversion.
If you form a portfolio composed of a bunch of highly risky stocks whose prices bounce around a lot, the portfolio itself will not be especially risky if the price movements of each of the component stocks are independent of one another, because then the movements will on average cancel out. But if the returns on the stocks are positively correlated, meaning they tend to go up and down together, then a portfolio of volatile stocks remains pretty risky; the benefits of diversification conferred by holding a portfolio of the stocks are not as great.
like the temperature in Singapore, highly stable. But stock prices, which we should interpret as attempts to forecast the present value of dividends, are highly variable.
When Shiller wrote his original paper, he did not think of it in psychological terms. He was merely reporting facts that were hard to rationalize. Not surprisingly, I read the paper through a behavioral lens, and saw him as a potential co-conspirator.
It is much easier to detect that we may be in a bubble than it is to say when it will pop, and investors who attempt to make money by timing market turns are rarely successful.
the law of one price. The law asserts that in an efficient market, the same asset cannot simultaneously sell for two different prices. If that happened, there would be an immediate arbitrage opportunity, meaning a way to make a series of trades that are guaranteed to generate a profit at no risk.
The term “open-end” means that the assets managed by the fund can grow or shrink depending on the preferences of its investors.
A closed-end fund works differently. Managers of the fund raise an initial amount of money, say $100 million, and that is it.
noise trader, as Black and Summers use the term,
