Knowledge Illusion in Decisions under Risk: The Impact of Perceived Expertise on Probability Weighting

51 Pages Posted: 30 May 2019 Last revised: 10 Dec 2019

See all articles by Maren Baars

Maren Baars

University of Muenster - Finance Center

Michael Goedde-Menke

University of Münster - Finance Center Münster

Date Written: December 10, 2019

Abstract

We empirically show that individuals have distinct attitudes towards different sources of risk. The processing of objective probabilities in decisions under risk depends on an individual’s perceived expertise regarding the underlying source. We conduct an experiment involving different gambles, i.e., risky games where objective probabilities are known, no further information-based advantages exist, and outcomes are independent of knowledge. The gambles are chosen based on their popularity to induce variation in participants’ perceived expertise. Although all objective probabilities are explicitly provided, we find that individuals engage in less severe probability weighting if they perceive their level of expertise to be higher regarding a gamble. This result suggests that individuals suffer from knowledge illusion in decisions under risk and highlights the importance of perceived (but irrelevant) expertise. Our findings foster a better understanding of the puzzling investor behavior observed in equity markets.

Keywords: risk, probability weighting, perceived expertise, stock market participation puzzle, home bias, local bias

JEL Classification: D81, D83, D91

Suggested Citation

Baars, Maren and Goedde-Menke, Michael, Knowledge Illusion in Decisions under Risk: The Impact of Perceived Expertise on Probability Weighting (December 10, 2019). Available at SSRN: https://ssrn.com/abstract=3383607 or http://dx.doi.org/10.2139/ssrn.3383607

Maren Baars

University of Muenster - Finance Center ( email )

Universitätsstraße 14-16
Münster, 48143
Germany

Michael Goedde-Menke (Contact Author)

University of Münster - Finance Center Münster ( email )

Universitätsstraße 14-16
Münster, 48143
Germany

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