The Winner's Curse: Behavioral Economics Anomalies - Then and Now by Richard Thaler and Alex Imas - Page 2 of 3

The Winner’s Curse: Behavioral Economics Anomalies – Then and Now by Richard Thaler and Alex Imas

People prefer sure things and tend to be risk adverse. Expected Utility Theory is the canonical model for risky decisions going forward. Expected utility combines the probability times the potential gain and the probability times the potential loss. To avoid risk the wins and losses should be equal and have equal probability. Diminishing sensitivity states that as the size of the change increases, the rate of impact falls. In other words, your first billion has a greater impact than you second billion. Ideally, you maximize your expected utility. Prospect Theory says that loses hurt more than wins feel good. It does not line up with expected utility theory which would imply that equal wins and loses should have equal emotional impact.

Expected utility theory would value a lottery ticket with a 10% chance of winning $100 two times the value of a ticket with a 5% chance to win $100. Insurance deals are not rational as they do not comply with expected utility theory. You are usually much better off in the long run if you avoid opting for insurance on things like phones and extended warranties. Low deductible health insurance plans are also a bad deal. People don’t realize it as the premiums are deducted from their paychecks so they don’t see monthly invoices. Doing a little math can save you hundreds per year.
In the long run, investing in equities (stocks) is much better than fixed rate investments (CDs). If you look and your portfolio value every day, you will experience almost as many loses as gains. If you do so once a decade, you will hardly ever see a loss. (Doug: I find that checking every couple months or so way less stressful that daily check ins.)

When it comes to now or later choices, many people make irrational decisions. Most people have too much tax deducted from their wages so they can get a big refund next year. In essence, they are giving the government a tax-free loan, which averages $3,000 per year. Many teachers spread their pay out over twelve months rather than taking it all in ten. They are giving their school district an interest free loan.
People need to be paid a lot to wait for a reward, but they are unwilling to pay very much to delay a fine. In one experiment, 64.8% declined a 2% return over two weeks even though it’s an annual 67% interest rate. Most won’t pay $50 more for an appliance that will save them $50 in electricity in just one year. Some will put the alarm clock on the other side of the room to make sure they get up early. Others purchase annual gym memberships because if they don’t go, they are wasting the sunk cost invested. Also, the next trip is free. (Doug: This is why I buy a yearly golf membership.)

Consumption appears to be excessively sensitive to income. Most people up their life-style as income increases. The fungibility assumption is what permits all components of wealth to be collapsed into a single number. People should optimize their consumption, but self-control is difficult. IRA’s help with self-control.
Some people don’t see wealth as fungible. 23% have credit card debt at the same time they have enough savings to pay it off. Rich people get richer because they reinvest their dividends and capital gains. People tend to reinvest home equity in a new home. It’s a good idea to increase your savings rate every time you get a raise.

We all do things that are dumb. That’s why economic theory can be wrong at times. To be coherent, a preference must be transitive. For example, If we like A better than B, and B better than C, liking A better than C would be transitive. Liking C better than A would be intransitive. If you like one option better than another but are willing to pay more for the second option, you are exhibiting preference reversal.
If you test speakers in a store and find the ones that sound better to be less attractive and buy them instead of the more attractive speakers that don’t sound quite as good, you will regret it when you no longer can compare the sound but have to look at unattractive speakers every day. Behavior is likely to vary across situations that economists consider to be identical.