Shane Legg on prospect theory and computational finance

Roko

People are not rational expected utility maximisers. When we have to make decisions, all sorts of cognitive biases and distortions come into play. Seminal work in this area was done by Kahneman and Tversky. They produced a model of human decision making known as prospect theory, work that Kahneman later won a Noble prize ...

... I looked at these investors and thought, “Hey, they’re just like reinforcement learning agents. No big deal. If I want to know what investors with probability weighting and a curved value function do, I can just brute force compute their optimal policy by writing down their Bellman equation and using dynamic programming. Easy!” It was a mystery to me why, seemingly, nobody else was doing that. So off I went to build software to do just this, starting with a simple Merton model…

... When we fired up my simulator and gave this distribution to an investor that had probability weighting: the investor took one look at that scary negative tail and didn’t want to invest in the stock. This is exactly what the model should predict. In short, we took realistic stock returns, and presented this to an investor with a realistic decision making process complete with a bunch of parameters that have been empirically estimated by others in previous work, and what we got out the other end was realistic investor behaviour!

Read the whole article here at Vetta Project.

People are not rational expected utility maximisers. When we have to make decisions, all sorts of cognitive biases and distortions come into play. Seminal work in this area was done by Kahneman and Tversky. They produced a model of human decision making known as prospect theory, work that Kahneman later won a Noble prize ...

... I looked at these investors and thought, “Hey, they’re just like reinforcement learning agents. No big deal. If I want to know what investors with probability weighting and a curved value function do, I can just brute force compute their optimal policy by writing down their Bellman equation and using dynamic programming. Easy!” It was a mystery to me why, seemingly, nobody else was doing that. So off I went to build software to do just this, starting with a simple Merton model…

... When we fired up my simulator and gave this distribution to an investor that had probability weighting: the investor took one look at that scary negative tail and didn’t want to invest in the stock. This is exactly what the model should predict. In short, we took realistic stock returns, and presented this to an investor with a realistic decision making process complete with a bunch of parameters that have been empirically estimated by others in previous work, and what we got out the other end was realistic investor behaviour!

Read the whole article here at Vetta Project.

This is interesting, but (as far as I know) a much better explanation as to why most people don't own stock is that they don't actually bother researching how to invest or spend much cognitive effort on investing.

Perhaps Napoleon's old statement needs a corollary: "Never attribute to a complicated model of behaviour contingent on the interconnection of numerous noisy empirical estimates that which is adequately explained by incompetence."

Sure, there will be a great many factors at work here in the real world that our model does not include. The challenge is to come up with a manageable collection of principles that can be observed and measured across a wide range of situations and that appears to explain the observed behaviour. For this purpose "can't be bothered" isn't a very useful principle. What we really want to know is why they can't be bothered.

For example, I know people who can be bothered going to a specific shop and queueing in line every week to get a lottery tick... (read more)

0roland17y

I was thinking about the same. The question is, how much research must you do in order for stock investing to become profitable comparing to other ways of investing? There is also the question of fees to pay, the less you invest, the more the fees weigh in.

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Shane Legg on prospect theory and computational finance

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Shane Legg on prospect theory and computational finance

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