If you haven't taken the analytical versus intuitive thinking mode Cognitive Reflection Test (CRT), you should do so at the PART I posting before continuing here.
One of the principles of Prospect Theory is that people do not have a constant risk aversion. In other words, people may avoid risk in some instances and seek risk in others. For example, we buy lottery tickets (risk seeking) and car insurance (risk avoidance).
Here is another illustration. Read and consider the two choices below.
Which option would you pick? You have the choice to receive either:
(A) $100 for certain, or
(B) flip a coin for a chance to $300 if heads or receive nothing if tails
Which option would you pick? You have the choice to pay either:
(A) $100 for certain, or
(B) flip a coin for a chance to pay nothing if heads or pay $300 if tails
Did you pick the safe alternative (choice A) for both? The risky alternative (choice B) for both? Or did you pick one safe choice and one risky choice?
Prospect Theory suggests that the tendency will be to pick the safe option in the first question and the risky option in the second. But not everyone behaves this way. One determinant of choice seems to be the thinking mode. For example, in a sample of financial planners, I found responses for the first question to be:
Note that the intuitive thinking planners tended to pick the safe choice when receiving the money while the analytical planners tended to take the gamble. These results are similar to those found by Shane Frederick in his much larger sample of a broader segment of the population. He found that 75% of the analytical people picked the gamble while 53% of the intuitive people picked the safe option. Analytical people may recognize a risk premium in the gamble. On average, people picking the gamble will receive $150 (the expected value of $0 and $300). That is a $50 risk premium over the safe choice.
For the choice of paying money (the second question), the financial planners choose:
Here, the majority of intuitive planners picked the gamble. People are often willing to take risk in order to get back to even. The analytical planners tended toward the safe payment.
Note that both the intuitive planners and the analytical planners tended to pick one safe option and one risky option. Intuitive people picked the safe option in the positive domain (receiving money) and the risky option in the negative domain (paying money). This is consistent with Prospect Theory. The analytical planners did the opposite.
What choices would be better from an investment perspective?
Go to the PART IV posting for a look at analytical/intuitive thinking and patience.
(See Shane Frederick, 2005, "Cognitive Reflection and Decision Making," Journal of Economic Perspectives, 19(4), pages 25-42 and John Nofsinger and Abhishek Varma, 2007, "How Analytical is Your Financial Advisor?" Financial Services Review, 16(4), 245-260.)
