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Hidden Skewness: On the Difficulty of Multiplicative Compounding Under Random Shocks

32 Pages Posted: 12 Nov 2013 Last revised: 8 Feb 2016

Ludwig Ensthaler

Humboldt University of Berlin - School of Business and Economics; German Institute for Economic Research (DIW Berlin)

Olga Nottmeyer

IZA Institute of Labor Economics; German Institute for Economic Research (DIW Berlin)

Georg Weizsacker

Humboldt University Berlin; DIW Berlin

Christian Zankiewicz

German Institute for Economic Research (DIW Berlin)

Multiple version iconThere are 2 versions of this paper

Date Written: February 8, 2016

Abstract

Multiplicative growth processes that are subject to random shocks often have an asymmetric distribution of outcomes. In a series of incentivized laboratory experiments we show that a large majority of participants either strongly underestimate the asymmetry or ignore it completely. Participants misperceive the outcome distribution's spread to be too narrow-band and they estimate the median and the mode to lie too close to the distribution's center, failing to account for the compound nature of average growth. The observed biases are measured irrespective to risk preferences and they appear under a variety of conditions. The biases are largely consistent with a behavioral model in which geometric growth is confused with linear growth. This confusion is a possible driver of investors' difficulties with real-world financial products like leveraged ETFs and retirement savings plans.

Keywords: behavioral economics, irrational expectations, binomial tree

JEL Classification: C91, D14, G02

Suggested Citation

Ensthaler, Ludwig and Nottmeyer, Olga and Weizsacker, Georg and Zankiewicz, Christian, Hidden Skewness: On the Difficulty of Multiplicative Compounding Under Random Shocks (February 8, 2016). DIW Berlin Discussion Paper No. 1337. Available at SSRN: https://ssrn.com/abstract=2353261 or http://dx.doi.org/10.2139/ssrn.2353261

Ludwig Ensthaler

Humboldt University of Berlin - School of Business and Economics ( email )

Spandauer Str. 1
Berlin, D-10099
Germany

German Institute for Economic Research (DIW Berlin) ( email )

Mohrenstraße 58
Berlin, 10117
Germany

Olga Nottmeyer

IZA Institute of Labor Economics ( email )

P.O. Box 7240
Bonn, D-53072
Germany

German Institute for Economic Research (DIW Berlin) ( email )

Mohrenstraße 58
Berlin, 10117
Germany

Georg Weizsacker (Contact Author)

Humboldt University Berlin ( email )

Spandauer Str. 1
Berlin, D-10099
Germany

DIW Berlin

Mohrenstr. 58
Berlin
Germany

Christian Zankiewicz

German Institute for Economic Research (DIW Berlin) ( email )

Mohrenstraße 58
Berlin, 10117
Germany

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