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Over-Reaction to Chance Events

Many people are quick to perceive casualregularity in random sequences of events. Thisobservation is called the hot hand fallacy. The

tendency to attach less importance to probabilityfluctuations causes the investors to overreact toany attention-grabbing information.

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Question 4

Which of the following sequences is more likely tooccur when a coin is tossed

HHHTTT or HTHTTH?

Most of people will choose HTHTTH

But dont too quick to judge

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Its just an illusion

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Recommendation 3

Ask yourself whether you have real reasons tobelieve that you know more than the market.

Before making an active decision, consider the

possibility that the trade is based on randomfactors. List the reasons why it isnt beforemaking the trade.

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Errors of Preference

The authors discuss the probability informationused by people in assessing risky prospects,assigning values to outcomes and combining values

and probabilities into preferences.

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Non-Linear Weighting of Probabilities

People tend to overvalue low probabilities andundervalue moderate and high probabilities.

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Question 5

You are facing a chance for gain of $20,000. You donot know the exact probability. Consider the threepairs of outcomes:

A. The probability is either 0% or 1%B. The probability is either 41% or 42%

C. The probability is either 99% or 100%

Are the three differences, A, B, and C, equallysignificant to a decision-maker?

Could you order them by their impact on preferences?

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People will pay more to raise the probability of adesirable event from 0 to 1%, or from 99% to 100%,than they will pay to increase the probability from41% to 42%

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People Value Changes, not States

Through this analysis, the authors state thatdecision maker is concerned with the gains andlosses of the gamble and not by how much he/she

receives in the end.

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Question 6

Imagine that you are richer by $20,000 than you aretoday, and that you face a choice between options:

A. Receive $5,000.

B. A 50% chance to win $10,000 and a 50% chance towin nothing.

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Question 7

Imagine that you are richer by $30,000 than you aretoday, and that you are compelled to choose one oftwo options:

A. Lose $5,000.B. A 50% chance to lose $10,000 and a 50% chance to

lose nothing.

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If you are like most other people

1. You probably paid very little attention to the initialstatement about being richer than you are by aspecified amount

2. You probably feel that the two problems are quitedifferent

3. If you choose the gamble in one of the problemsand the sure thing in the other, you probably chose

the gamble in question 7 and the sure thing inquestion 6.

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The important morals from this story

1. It is always possible to frame the same decisionproblem in broader terms (such as wealth) on innarrower terms (such as gains and losses); broadand narrow frames often lead to differentpreferences.

2. Rationally is the best served by adopting broadframes, and by focusing on states (such as wealth)

rather than on changes (such as gain and losses).

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Recommendation 4

When presenting alternative courses of action toclients, do so using the broadest available frame.

Make sure the frame chosen has relevance for the

client (e.g., Wealth) For client whose primary goal is retirement, consider

converting the level of wealth into the amount ofannuity income that can be expected during

retirement.

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Value Function

The authors underline the importance of twocharacteristics of value function in understandingdecisions, namely loss aversion and near-proportionality of risk attitudes.

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Two important characteristics

1. The function is steeper for losses than for gains, afeature called loss aversion.

2. The two limbs of function are each described by a

particular mathematical relationship, whichimplies a result that we will call near-proportionality of risk attitudes.

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Question 8

Someone offers you a bet on the toss of a coin. If youlose, you lose $100. What is the minimal gain that

would make this gamble acceptable?

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Coin toss: lose $100, How much to win?

The Solution : Coin toss: win $200 to $250, lose $100

Weight possible loss 2.5 times possible 1 toss Utility = 50%x1x200 + 50%x2.5x(-100) = -25

2 toss Utility = 25%x1x400+50%x1x250+25%x2.5x(-100)=+25

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Recommendation 5

Some individuals may be more loss averse thanothers. Assess how loss averse your client is.

Do not recommend very risky investments to loss-

averse clients. They will accept such investmentsonly if they optimistically underestimate the risks.

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Question 9

What sure gain is just as attractive as the this riskyprospect a 50% chance to gain $1,000 or a 50%chance to gain nothing?

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Most people will set a cash-equivalent of less than$400 for the gamble of Question 9.