Fooled By Randomness? Financial Decision-Making Under Model Uncertainty
Posted: 21 Oct 2014 Last revised: 30 Nov 2016
Date Written: March 22, 2016
This study considers model uncertainty about tail risk, the possibility of learning and how this affects choice. I designed an experiment involving repeated risk taking where assets can yield steady streams of good outcomes but eventually inflict a major loss that annihilates all previous gains. Learning about those assets' risk/reward profiles is crucial yet challenging. The main findings are: 1) When asked to perform a stylized version of the task, participants managed to learn in a Bayesian way; 2) However, many still chose to invest in these assets, apparently owing to an overwhelming desire to "pick pennies." These findings suggest that the key issue with tail risk is not the most commonly expected one, namely, that people cannot assess it, but rather that people cannot deal with it due to purely behavioral issues related to limited self-control.
Keywords: Tail Risk, Learning, Self-Control, Negative Skewness, Neurofinance
JEL Classification: C91, D83, D87, G02, G11
Suggested Citation: Suggested Citation