On Loss Aversion, Level-1 Reasoning, and Betting
30 Pages Posted: 13 Sep 2013
Date Written: April 1, 2013
Previous research suggests that human reaction to risky opportunities reflects two contradicting biases: "loss aversion", and "limited level of reasoning" that leads to overconfidence. Rejection of attractive gambles is explained by loss aversion, while counterproductive risk seeking is attributed to limited level of reasoning. The current research highlights a shortcoming of this popular (but often implicit) "contradicting biases" assertion. Studies of "negative-sum betting games" reveal high rate of counterproductive betting even when limited level of reasoning and loss aversion imply no betting. The results reflect two reasons for the high betting rate: initial tendency to participate and slow learning. Under certain conditions, the observed betting rate was higher than the rate predicted under random choice even after 250 trials with immediate feedback. These results can be captured with a model that assumes a tendency to select strategies that have led to good outcomes in a small set of similar past experiences, and allows for an initial framing effect.
Keywords: Loss aversion, Level-1 reasoning, Samuelson’s Colleague, acquiring a company problem, market for lemons
JEL Classification: C63, C73, D03, D82, D83
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