Christmas reading - Kahneman and Tversky

I realize that the holiday season is over (boy do I realize it, since I am back in the classroom as of today), but I thought I would report on a couple of books I read over the break.

Choices, Values, and Frames
by Daniel Kahneman and Amos Tversky

This is a collection of papers on cognitive psychology as applied to economics and decision making. Kahneman and Tversky were pioneers in what is now known as behavioral economics. The papers are clearly written and offer a nice introduction to this field.

As you can tell from some of my previous posts mocking the idea of strongly efficient markets, I am not myself a big believer in the rationality or analytical power of individuals who make up markets. However, this does not mean I doubt the power of markets as aggregators of information, and on this subject I highly recommend Surowiecki's book The Wisdom of Crowds. Certainly, it is not excluded that a machine could function usefully even if many of its subcomponents are faulty :-)

I won't try to summarize everything in the book, which at minimum provides a nice compendium of cognitive quirks uncovered in surveys and laboratory observations. One that I found quite interesting is the prevalence of risk aversion, extending even to very small wagers. The typical person's utility function, as extracted from experimental observation, is not at all linear even for small amounts at risk - the pain of a loss exceeds the pleasure of a gain of equal size.

It seems reasonable to assume that individual utility functions are logarithmic - a gift of $1000 brings proportionally less pleasure to a billionaire than to a millionaire. But there is good evidence that this is not so, and indeed M. Rabin, in one of the papers, shows that the aversion to small losses cannot be accommodated by such a model of utility. It seems that our brains constantly set reference points ("zero points") relative to which we measure loss or gain.

If indeed our brains constantly (say on monthly to yearly timescales) reset their financial zero points, and are naturally risk averse, then volatility itself is a painful phenomena. One interesting idea of Rabin's is that this explains the (unnaturally?) high value of the equity risk premium.

In my opinion, investors have been trained in recent decades to believe that small losses are only temporary and that equity markets almost always go up over the long run. This makes them more resistant to loss aversion and leads to a smaller equity risk premium (and correspondingly high P/E ratios).