Behavioral finance

There is an emerging field called Behavioral finance that attempts to study the human side of the markets. Interesting stuff, but not of much use to the mainstream.

They just gave the Nobel Prize in Economics to one of the premiere academics in this field, Daniel Kahneman. He along with Amos Tversky came up with “Prospect theory” One very important result of Kahneman and Tversky’s work is demonstrating that people’s attitudes toward risks concerning gains may be quite different from their attitudes toward risks concerning losses.

For example, when given a choice between getting $1000 with certainty or having a 50% chance of getting $2500 they may well choose the certain $1000 in preference to the uncertain chance of getting $2500 even though the mathematical expectation of the uncertain option is $1250. This is a perfectly reasonable attitude that is described as risk-aversion. But Kahneman and Tversky found that the same people when confronted with a certain loss of $1000 versus a 50% chance of no loss or a $2500 loss do often choose the risky alternative. This is called risk-seeking behavior. Essentially, they reasoned that we are not generally risk averse, we are loss averse.

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