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

36 Pages Posted: 15 May 2014

See all articles by Ludwig Ensthaler

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: April 14, 2014

Abstract

Multiplicative growth processes that are subject to random shocks often have a skewed distribution of outcomes. In a number of incentivized laboratory experiments we show that a large majority of participants either strongly underestimate skewness or ignore it completely. Participants misperceive the outcome distribution’s spread to be far too narrow-band and they estimate the median to lie too close to the distribution’s center. The observed bias in expectations is irrespective to risk preferences and fairly robust to feedback. It is consistent with a behavioral model in which geometric growth is confused with linear growth. The misperception is a possible explanation of investors’ difficulties with real-world financial products like leveraged ETFs.

Keywords: behavioral economics, irrational expectations, binomial tree

JEL Classification: C910, D030, D140, G020

Suggested Citation

Ensthaler, Ludwig and Nottmeyer, Olga and Weizsacker, Georg and Zankiewicz, Christian, Hidden Skewness: On the Difficulty of Multiplicative Compounding Under Random Shocks (April 14, 2014). CESifo Working Paper Series No. 4760. Available at SSRN: https://ssrn.com/abstract=2436835

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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