Thinking Fast and Slow 29 The Fourfold Pattern

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Here Kahneman studies how we combine expected probabilities of an event and how we value it in order to assign weights to different outcomes. That way, we assess how desirable it is for a person and what is its likelihood to happen.

Two main biases are presented here: the possibility effect and the certainty effect. The fact that we can change something from impossible to happen, to have certain probability to happen has a disproportionate effect on us. That’s the reason we buy lottery tickets: it rises a 0% probability to gain something to a very low probability. It is also the reason why we fear very small risks: the operation is quite safe, but there is a 1% risk that something bad happens.

In the certainty effect we know that something is going to happen, not that it has a 95% or a 99% to happen that it is going to happen for sure. This also has disproportionate effects on us.

So, Kahneman’s point here is that there is a relevant difference between the real probability of an outcome and how people calculate such probabilities. This clashes with Morgernstern and von Neumann theory of rational choice, that expects humans to be natural calculators of real mathematical probabilities.

To solve such a problem, within the prospect theory model, Kahneman and Tverksy proposed what is known as The Fourthfold pattern. Such schema predicts feeling and behavior of real humans considering the four combination of two variables: Probability (high or low) and expected value (gains or loses). In this model, emotions play a very substantial role, powered by risk aversion.

fourthfoldPatern

This chapter has the same problem we discussed when talking about Mr W. speciality or Linda the accountant. Yes, people have a different impression of risk and probability that the one that is taught in mathematics. So what? Consider the possibility effect: I am myopic and I need glasses. Surgery could solve that, but let’s say that there is a very small risk (less than %1) of losing my sight and becoming blind. I don’t care what a mathematician might say, I’m not going to take that risk, I prefer wearing glasses. If that makes me irational, so be it.

Kahneman is sympathetic with people like me, and admit that “The decisions described by the fourfold pattern are not obviously unreasonable” but says that in the long run, they are much costly.

The general discussion of gambling as a way to study how we make decisions, reminded me of Taleb and his critiques in Antifragile on how casinos are a very very bad model for studying risk. In real life, there is no way to ponder the probabilities of a certain event to happen, so at best, casino-based models are useless for any real risk assesment.

Thinking, Fast and Slow. 28. Bad Events

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Evolution has endowed us with a bigger sensitivity to bad things than to to good ones. That makes perfect sense since avoiding dangers efficiently contributes more to the survival of an individual than taking advantage of opportunities. What is good and what is bad is sometimes hardwired in our nervous system but sometimes is relative to a perceived reference point.

Loss aversion is a particular case of this universal asymmetric sensitivity. We value much more a loss than an equivalent gain. At first sight, this is shared wisdom and should surprise no one. The chapter tries to convey the idea that implications of this phenomenon go much deeper than what can be seen at first sight and offers us several examples.

Two appear to me as the most relevant.

First, it explains the universal resistance to reform, no matter how evident its gains may seem and how deficient the current situation may be. Those few that are going to loose with the change are going to fight much more that those who may end up gaining with it.

Second, it introduces the idea that economic action has to take into account perceived fairness.

This second point came as a revolution in the rational human based economic theory but I suspect that this ideas have been used in marketing and business for centuries. Everybody knows that if you want that those who can pay more to pay more, instead of raising the price for those who have a job, you have to raise the price for everybody and then make discounts for unemployed. The result is the same and you will be loved instead of despised.

Thinking Fast and Slow 27: The Endowment Effect

In this chapter we find some more examples of “theory induced blindness”‘ and how the idea of indiference can lead us to forget about previous conditions while making a decision, which is clearly a bad idea, but seems quite common in economics that don’t consider loss aversion while one person has to move from one job to an “equivalent” one.

The endowment effect, tested in various original experiments, shows how when something belongs to us, suddenly we value it more. When I am introduced to an item, a cup, for example, I wouldn’t pay more than $5. But once it is mine, and I’m asked how much I’d like to receive for it, I might end up asking for $15.

Prospect theory can solve that, pointing out at the fact that now the reference point to value the cup has changed.

Not everything generates an endowment effect. In order to do so it has to be an item you can use. If you use for exchange it won’t be activated. So if you sell cups and you won’t feel any special relationship with them and just sell them at market value.

According to others experiments, physical possession of the object is key to create an endowment effect. Being poor can also diminish or even making dissapear the endowment effect.

My overall impression is that any decision implies so many emotional and irational implications, that prospect theory can’t really take into account whether endowment effect is going to be activated and with what strenght. Unfortunately, Kahneman seems to be best when saying why we are not rational and less good when proposing alternative models.

Thinking, Fast and Slow. 26. Prospect Theory

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This chapter presents us with a detailed description of prospect theory which should address the deficiencies that, as we saw in chapter 25, the 250 year-old utility theory presented.

Instead of calculating the utility that a certain amount of money represents for a person just putting it in relation with the person’s wealth, prospect theory uses a different approach to predict human preferences. It is based in three principles:

1. Evaluation is relative to a neutral reference point which is not the wealth of the person involved but is a characteristics of the choice presented to it and the expectations of gains and losses that it generates.

2. There is diminishing sensitivities to both losses and gains.

3. Perceived utility is asymmetrical for gains and losses being much bigger for the latter. This is loss aversion and is the basic point of the chapter.

Here comes to my mind Taleb, the story teller, when he explains that if you look at your portfolio once in a year, you see that you are up 5% and you are happy. But if you look everyday, almost half of the days you are losing money and you live a miserable life because the bad feelings that you get are not offset by what you get the days that you are up.

And talking of Taleb the Impaler, the chapter ends with a strange final section where the Kahneman tries somehow to recover the value of utility theory after all the bashing that it has received in the last two chapters. I kind of false modesty, probably, to soften relationships with some colleges. This is something Taleb has never done.

God bless him.