Periodic Reporting for period 3 - SkewPref (Skewness Preferences – Human attitudes toward rare, high-impact risks )
Berichtszeitraum: 2022-04-01 bis 2023-09-30
The large share of decisions that humans make involve at least some risk. Among the most important risks we face are rare, high-impact risks (i.e. risks involving rare, high-impact events). For example, many useful medications come with rare but devastating side effects. The goal of this project is to provide a fundamental understanding of humans’ skewness preferences—our attitudes toward such rare, high-impact risks. As will be shown, skewness preferences are much more influential on behavior than previously realized, and thus must take a central place in the economic analysis of risk. One reason is that skewness preferences have unexpected and far-reaching implications in dynamic decision situations, and thus their complex interaction with time is a major topic of this project. Besides offering fundamental results on the psychology of risk-taking, we explore applications, for example, in the domain of finance.
During the first half of the project, much work focused on skewness preferences in static (i.e. one-shot) decision situations. We developed a general notion of what it means that skewness preferences are “strong,” that is, that humans are really sensitive to rare, high impact risks. We then studied this notion in various well-known theories of human risk preferences (for example, the psychologically motivated prospect theory of Kahneman and Tversky). We could show that leading theories make different predictions regarding the strength of skewness preference. While the leading “rational” theory, expected utility theory, cannot explain the strongest type of skewness preference we define, psychologically grounded (“behavioral”) theories can. We believe that this insight is important for economic modeling quite generally because most economic models require assumptions about how humans deal with risk and skewed risks in particular.
Further work was concerned with the repeated risk-taking of skewed risks. An extensive body of theoretical and experimental literature has shown that, in one-time decision situations, humans are skewness-seeking and dislike risks that feature unlikely but large losses (i.e. negatively skewed risks). We showed that, contrary to intuition, the often-observed phenomenon of penny-picking—repeatedly taking negatively skewed risks—is not at odds with skewness-seeking, but, to the contrary, may even be caused by it. The skewness of the distribution that results from repeatedly taking a skewed risk depends in non-trivial ways on the risk-taking strategy and may even differ in sign from that of the individual risk. With sufficient time available, every risk—no matter how negatively skewed—can be gambled in such a way that, in total, skewness is positive. Because recent work has shown that skewness is decisive for whether risk is taken, this result may be important for economics and finance on a fundamental level.
Another work stream focused on whether, and how, skewness preferences reflect in the prices of financial assets (e.g. stocks and options). Specifically, we studied the asset pricing implications of skewness preferences as implied by probability weighting (the idea that investors overweight rare, high impact events). We obtained and empirically validated several novel implications for asset prices, in particular on what experts call the option-implied premiums on variance and skewness.
Several other projects are currently in progress in will be described in the final scientific report.
Further work was concerned with the repeated risk-taking of skewed risks. An extensive body of theoretical and experimental literature has shown that, in one-time decision situations, humans are skewness-seeking and dislike risks that feature unlikely but large losses (i.e. negatively skewed risks). We showed that, contrary to intuition, the often-observed phenomenon of penny-picking—repeatedly taking negatively skewed risks—is not at odds with skewness-seeking, but, to the contrary, may even be caused by it. The skewness of the distribution that results from repeatedly taking a skewed risk depends in non-trivial ways on the risk-taking strategy and may even differ in sign from that of the individual risk. With sufficient time available, every risk—no matter how negatively skewed—can be gambled in such a way that, in total, skewness is positive. Because recent work has shown that skewness is decisive for whether risk is taken, this result may be important for economics and finance on a fundamental level.
Another work stream focused on whether, and how, skewness preferences reflect in the prices of financial assets (e.g. stocks and options). Specifically, we studied the asset pricing implications of skewness preferences as implied by probability weighting (the idea that investors overweight rare, high impact events). We obtained and empirically validated several novel implications for asset prices, in particular on what experts call the option-implied premiums on variance and skewness.
Several other projects are currently in progress in will be described in the final scientific report.
The research thus far has advanced the state of the art in the research field of decision analysis (and decision-making under uncertainty in particular) in various ways. We advanced the fundamental understanding of skewness preferences in static and dynamic decision situations. In particular, we succeeded in establishing a theory-free notion of skewness preference, the first to allow for a non-trivial analysis in leading theories of decision-making under risk. We gave a comprehensive theoretical analysis of the forces that are at work in determining the repeated risk-taking of skewed risks. And we derived and tested novel and important implications of skewness preferences for asset pricing, in particular concerning the so-called variance premium and the so-called skewness premium.
During the second half of the project period, additional focus is put on the repeated risk-taking of skewed risks and applications. Moreover, the mentioned theoretical studies will be complemented by experimental ones.
During the second half of the project period, additional focus is put on the repeated risk-taking of skewed risks and applications. Moreover, the mentioned theoretical studies will be complemented by experimental ones.