Pls answer both questions for UPVOTE a) Define the uncertainty effect (UE). What
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Question
Pls answer both questions for UPVOTE
a) Define the uncertainty effect (UE). What are the three possible reasons for the UE? Simonsohn (2009) examined the rationale behind the UE using experiments. Summarize the findings from the experiments.
b) The efficient market hypothesis predicts that “the future returns on the two portfolios, the Winners and the Losers, should be the same since you are not supposed to be able to predict changes in stock prices from past returns.” Thaler (2018) mentioned that he and his coauthors had a different prediction. What was their prediction? Explain the rationale behind their prediction
Explanation / Answer
a) As identified by Simonsohn(2009),the theory of Uncertainty Effect or UE usually states that the willingnes to pay for people are usually less for a gamble or a lottery with binary or two possible outcomes than the willingness to pay for its worst or less better outcome.In other words,under any uncertainty about the outcome of any lottery or gamble situation,people are generally more risk aversive which reflects in their less willingness to pay.Conversely,if they certainly know without any uncertainty about the worst or relatively les better outcome of the gamble situation,their willingness to pay usually increases compared to the former case of uncertainty.
Simonsohn(2009) also points out three possible reasons behind the Uncertainty Effect or UE.First,uncertainty or risk aversion is a natural phenomenon that is already a direct part of our utility function.Hence,uncertainty intrinsically governs individual behavior or decisions under any uncertain situation.Secondly,the information about the better or high paying outcome under any binary lottery or gamble situation already undermines the percieved sense or value of its worst or less paying outome and thus it diminishes the value of the entire lottery or gamble.This implies that as people are aware about the better or high paying outcome of the gamble,they put less importance or emphasis on the low paying outcome and the entire lottery or gamble as a whole.Thirdly,the UE may also arise from the mistaken notion that one of the outcomes of the binary lottery or gamle might result in a $0 payoff.Assuming that the participants are completely risk aversive,they might have the mistaken apprehension that they might not gain from the lottery and hence loose the entire ammount of their bet in which case they get nothing.Thus,the uncertainty of the outcome and the possibility of loosing all is another factor that engenders the UE.
The author presented two specific experiments with binary lottery or gambling to estimate the extent or magnitude of UE effect.In the first experiment,there were two hundred and seventy nine particiapants mostly consisting of University of Pennsylvania undergraduate students who were aksed to answer some hypothetical questions about their willingness to pay as part of a series of surveys and questionaire in exchange for which they would recieve monteray rewards.The study consisted of six conditions which ideally represented differnt pairs of various low and high valued items and reflected whether participants expressed their willingnes to pay for each of the two outcomes of the experiment.The first outcome represents the certainty condition where the participants expressed their willingness to pay for each of the pairs and the second one indicated the willingness to pay for the particiapnts under binary situation with equal probability of achieveing the high/low valued items.Hence,in the second case,the outcome is uncertain where participants have equal chance of achieveing both outcomes.In this experiment any possibility of 0 payoff from the gamble is completeley removed.
The six item pairs offered gift items for Barnes and Nobles worth $50 and $100,gift certificates for Pod again worth of $50 and $100 which is a high end Asian Fusion restaurant located near the University campus and an offer for a three course meal for either two or four people also at Pod.
Based on the empirical estimations of the first experiment,the UE effect in this case is not apparently caused by the fact that awarenes or information about the high valued outcome diminishes the importance or value for the lower valued one.It indicates that the participants in the experiment have actually valued all of the outcomes equally without unequal importance for the outcomes.However,for majority of the participants the UE effect has been prominent and widespread.Furthermore,the magnitude of the UE effect is also evidently high among the participants.
The second experiment basically consisted of a questionaire where two alternative comprehension questions were asked to the participants.The first question asks about the lowest possible outcome of the lottery/gamble to essentially access the percentage of participants who actually think that there is a possibility of earning 0 payoff from te lottery.The second question asks a true/false question that whether the lottery from the first experiment offered the $50 gift certificate from Barnes and Nobles with 100% certainty.
In the second experiment,one hundred ninety six University of Pennsylvania undergraduates participated as part of series and surveys and questionaire.Initially all participants expressed their willingness to pay for $100 that is to recieved one year later and for a lottery that would offer a $50 or a $100 gift certificate from Barnles and Nobles with equal probability.Then the participants were asked the two comprehension questions as part of the experiment stated above.
Now,from an overall point of view the results of the second experiment suggest that the UE effect is not necessarily dictated or influenced by the apprehension of an extremely low payoff or a 0 payoff from lottery or gamble situations.As indicated by the expressed willingness to pay by the participants,it is apparent that individuals do not always fear that they would actually loose from any uncertain situation or will not have any positive gain.However,as pointed out,it is important to conduct a symmetric comprehension check across all conditions to reduce the risk of any statistical bias in the study which mainly includes elimination bias.
b) Richard Thaler in his phenomenal article "From Cashews to Nudges:The Evolution of Behavioral Economics." basically contends that decision making under any asymmetric information or uncertain scenario is evidently governed by the arrangement of choices or options that are offered to us or individuals.Therefore,choice designing or architecture is an important component that drives us to make better decisions under uncertainty or imperfect information.Considering the market hypothesis which refers to the uncertainty or asymmetric information about past market outcomes which influences predictions about future market returns or investment outcomes,there should be some specific choice architecture or proper arrangements of the market choices where people can invest safely to minimize the risk of loss.Now,observe that in this case,the goal of proper choice arrangement is to enhance the probability of success/gains and diminish the probabaility of loosing as much as possible which negates the equal probability of both winning and loosing from market investment.
In this regard,the proper arrangement of choices might imply various investment plans which might offer various policies and regulations safeguarding against market risks such as stock price fluctuations,limited predictability about market conditions,changes in interest rates which determines the rate of return on any financial investment,changes in government financial policies and so forth.Thus,various types of investment plans can provide different choices and policies to the investors to explore and choose from which would expectedly reduce the probability of financial loss and safeguard against any market related risks and uncertainty.Thus,as risk aversive individuals the investors can maximize their chances of winning from any particular investment given the market constraints and limitations.Therefore,appropriate choice arrangements or designing can influence individual decisions under uncertainty and consequently enable individuals to make safer and wiser decisions with reduced risk factor.
Citations
https://pubs.aeaweb.org/doi/pdfplus/10.1257/aer.108.6.1265
https://repository.upenn.edu/cgi/viewcontent.cgi?article=1299&context=oid_papers