Heuristic Modes of Decision Making and Survival in Financial Markets

Ani Guerdjikova () and John Quiggin
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Ani Guerdjikova: GAEL - Laboratoire d'Economie Appliquée de Grenoble - Grenoble INP - Institut polytechnique de Grenoble - Grenoble Institute of Technology - INRA - Institut National de la Recherche Agronomique - CNRS - Centre National de la Recherche Scientifique - UGA [2016-2019] - Université Grenoble Alpes [2016-2019]

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Abstract: We consider the impact of partial awareness in the form of a restriction of the state space on equilibrium allocations in financial markets. We consider a decision maker (DM) who is unaware of some of the possible states of the world, but is aware of his unawareness. We show, by extending the model of Grant and Quiggin (2015) the DM's perception of the state space can be represented by a partition of the original state space. Even if such a decision maker has correct information about the relative likelihoods of the events of which he is aware, his beliefs on the generated partition will be in general wrong. Furthermore, such a decision maker can be shown to behave as if he restricts his portfolio choice to a subset of the available assets with payoffs measurable w.r.t. his awareness partition and thus avoids "surprises". Such behavior implicitly follows a heuristic proposed by Gigerenzer (2014): "Never buy financial products you do not understand". We then study the effect of differential awareness on survival. We consider a financial market, in which all trades are executed at time 0, and in which agents can differ w.r.t. their level of awareness. We demonstrate that the heuristic to not invest into assets one does not understand allows the partially aware agent to survive, but only if his beliefs on his awareness partition are at least as close to the truth as the beliefs of a more aware agent with a finer partition. While examples of such beliefs are easy to generate when both agents are partially aware, in general, partially aware agents will have wrong beliefs and will thus disappear in the presence of fully aware agents with correct beliefs. In the last part of the paper, following Grant and Quiggin (2015), we introduce a second heuristic, aversion to unforeseen unfavorable surprises. An agent who uses this heuristic holds a minimal number of bonds in his portfolio. This heuristic allows us to establish survival of partially aware agents, regardless of whether their beliefs are correct. In this sense, aversion to unforeseen unfavorable surprises can be viewed as an ecologically rational heuristic. Asset prices in such an economy reflect the potentially incorrect beliefs of the fully aware agents and replicate the well-known equity premium puzzle.

Date: 2018-06-25
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Published in FUR 2018, Foundations of Utility and Risk Conference (FUR), Jun 2018, York, United Kingdom

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Working Paper: Heuristic Modes of Decision Making and Survival in Financial Markets (2018)
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