Forbes: Nobel Laureate Debunks Economic Theory
NEW YORK – Daniel Kahneman isn't an economist, but he wins prizes like one. A psychology professor at Princeton's Woodrow Wilson School of Public and International Affairs, Kahneman won the Nobel Prize in economics last month for his work–much of it done with the late Amos Tversky–on decision-making under uncertainty.
The Royal Swedish Academy of Sciences cited the professor for "demonstrat[ing] how human decisions may systematically depart from those predicted by standard economic theory." In reality, people often act irrationally. They may focus too much on the near term; or they may be overconfident, thinking they know what they don't know, or putting too much stock in their own beliefs. …
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What's the difference?
To give you an example, consider the following: You have two people, both of whom get their quarterly returns on their stock portfolios. One of them learns his wealth has gone from $1 million to $1.2 million, and the other one learns his wealth has gone down from $4 million to $3.5 million. I can ask you two questions. I can ask you who is happier. There is no question the first one is happier than the second. Then I can ask you who is better off financially. The second one is better off. Bernoulli's analysis was in terms of who is better off financially–basically in terms of wealth. But when people think of the outcomes of their decisions, they think much more short term than that. They think in terms of gains and losses. That was the basic insight.
How does that that affect decision-making?
It turns out it affects their decision-making in very major ways. If you think in terms of major losses, because losses loom much larger than gains–that's a very well-established finding–you tend to be very risk-averse. When you think in terms of wealth, you tend to be much less risk-averse. I'll give you an example: Suppose someone offered you a gamble on the toss of a coin. If you guess right, you win $15,000; if you guess wrong, you lose $10,000. Practically no one wants it. Then I ask people to think of their wealth, and now think of two states of the world. In one you own [your current assets] minus $10,000 and in the other you own [your current assets] plus $15,000. Which state of the world do you like better? Everybody likes the second one. So when you think in terms of wealth–the final state–you tend to be much closer to risk-neutral than when you think of gains and losses. That's the fundamental way prospect theory departs from utility theory.
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