Re-visions of rationality?

Empirical evidence suggests proponents of the ‘adaptive toolbox’ framework of human judgment need to rethink their vision of rationality

Decision Making for Inconsistent Expert Judgments Using Negative Probabilities

In this paper we provide a simple random-variable example of inconsistent information, and analyze it using three different approaches: Bayesian, quantum-like, and negative probabilities. We then show that, at least for this particular example, both the Bayesian and the quantum-like approaches have less normative power than the negative probabilities one.Comment: 14 pages, revised version to appear in the Proceedings of the QI2013 (Quantum Interactions) conferenc

Which heuristics can aid financial-decision-making?

© 2015 Elsevier Inc. We evaluate the contribution of Nobel Prize-winner Daniel Kahneman, often in association with his late co-author Amos Tversky, to the development of our understanding of financial decision-making and the evolution of behavioural finance as a school of thought within Finance. Whilst a general evaluation of the work of Kahneman would be a massive task, we constrain ourselves to a more narrow discussion of his vision of financial-decision making compared to a possible alternative advanced by Gerd Gigerenzer along with numerous co-authors. Both Kahneman and Gigerenzer agree on the centrality of heuristics in decision making. However, for Kahneman heuristics often appear as a fall back when the standard von-Neumann-Morgenstern axioms of rational decision-making do not describe investors' choices. In contrast, for Gigerenzer heuristics are simply a more effective way of evaluating choices in the rich and changing decision making environment investors must face. Gigerenzer challenges Kahneman to move beyond substantiating the presence of heuristics towards a more tangible, testable, description of their use and disposal within the ever changing decision-making environment financial agents inhabit. Here we see the emphasis placed by Gigerenzer on how context and cognition interact to form new schemata for fast and frugal reasoning as offering a productive vein of new research. We illustrate how the interaction between cognition and context already characterises much empirical research and it appears the fast and frugal reasoning perspective of Gigerenzer can provide a framework to enhance our understanding of how financial decisions are made

Investment Model Uncertainty and Fair Pricing

Modern investment theory takes it for granted that a Security Market Line (SML) is as certain as its "corresponding" Capital Market Line. (CML). However, it can be easily demonstrated that this is not the case. Knightian non-probabilistic, information gap uncertainty exists in the security markets, as the bivariate "Galton's Error" and its concomitant information gap proves (Journal of Banking & Finance, 23, 1999, 1793-1829). In fact, an SML graph needs (at least) two parallel horizontal beta axes, implying that a particular mean security return corresponds with a limited Knightian uncertainty range of betas, although it does correspond with only one market portfolio risk volatility. This implies that a security' risk premium is uncertain and that a Knightian uncertainty range of SMLs and of fair pricing exists. This paper both updates the empirical evidence and graphically traces the financial market consequences of this model uncertainty for modern investment theory. First, any investment knowledge about the securities risk remains uncertain. Investment valuations carry with them epistemological ("modeling") risk in addition to the Markowitz-Sharpe market risk. Second, since idiosyncratic, or firm-specific, risk is limited-uncertain, the real option value of a firm is also limited-uncertain This explains the simultaneous coexistence of different analyst valuations of investment projects, particular firms or industries, included a category "undecided." Third, we can now distinguish between "buy", "sell" and "hold" trading orders based on an empirically determined collection of SMLs, based this Knightian modeling risk. The coexistence of such simultaneous value signals for the same security is necessary for the existence of a market for that security! Without epistemological investment uncertainty, no ongoing markets for securities could exist. In the absence of transaction costs and other inefficiencies, Knightian uncertainty is the necessary energy for market trading, since it creates potential or perceived arbitrage (= trading) opportunities, but it is also necessary for investors to hold securities. Knightian uncertainty provides a possible reason why the SEC can't obtain consensus on what constitutes "fair pricing." The paper also shows that Malkiel's recommended CML-based investments are extremely conservative and non-robust.capital market line, security market line, beta, investments, decision-making, Knightian uncertainty, robustness, information-gap, Galton's Error, real option value

Decision Making and Trade without Probabilities

What is a rational decision-maker supposed to do when facing an unfamiliar problem, where there is uncertainty but no basis for making probabilistic assessments? One answer is to use a form of expected utility theory, and assume that agents assign their own subjective probabilities to each element of the (presumably known) state space. In contrast, this paper presents a model in which agents do not form subjective probabilities over the elements of the state space, but nonetheless use new information to update their beliefs about what the elements of the state space are. This model is shown to lead to different predictions about trading behavior in a simple asset market under uncertainty. A controlled laboratory experiment tests the predictions of this model against those of expected utility theory and against the hypothesis that subjects act na¨ıvely and non-strategically. The results suggest that a lack of subjective probabilities does not imply irrational or unpredictable behavior, but instead allows individuals to use both what they know and knowledge of what they do not know in their decision making. Comment un décideur rationnel est-il censé réagir face à un problème qui ne lui est pas familier lorsquâil existe une certaine incertitude, et en lâabsence dâune base sur laquelle effectuer des estimations probabilistes? Une solution consiste à utiliser une forme de la théorie de lâutilité espérée et de présumer que les agents attribuent leurs propres probabilités subjectives à chaque élément de la représentation dâétat (sans doute connue). Par contraste, notre article présente un modèle où les agents ne forment pas de probabilités subjectives sur les éléments de la représentation dâétat, mais utilisent de nouveaux renseignements afin de mettre à jour leurs croyances sur les éléments formant la représentation dâétat. Le comportement des échanges avec ce modèle dans un marché dâactifs simple et incertain nous mène à des prédictions différentes. En utilisant une expérience contrôlée en laboratoire, nous avons vérifié les prédictions de ce modèle contre celles de la théorie de lâutilité espérée et contre lâhypothèse que les sujets agissent avec naïveté et sans recourir à une stratégie. Les résultats suggèrent quâun manque de probabilités subjectives nâimplique pas un comportement irrationnel ou imprévisible, mais permet plutôt aux individus dâutiliser autant lâinformation quâils possèdent que la connaissance de lâinformation quâils ne possèdent pas dans leur prise de décision.Uncertainty; non-expected utility; incomplete preferences; ambiguity., Incertitude, utilité non espérée, préférences incomplètes, ambiguïté.

Technology assessment between risk, uncertainty and ignorance

The use of most if not all technologies is accompanied by negative side effects, While we may profit from today’s technologies, it is most often future generations who bear most risks. Risk analysis therefore becomes a delicate issue, because future risks often cannot be assigned a meaningful occurance probability. This paper argues that technology assessement most often deal with uncertainty and ignorance rather than risk when we include future generations into our ethical, political or juridal thinking. This has serious implications as probabilistic decision approaches are not applicable anymore. I contend that a virtue ethical approach in which dianoetic virtues play a central role may supplement a welfare based ethics in order to overcome the difficulties in dealing with uncertainty and ignorance in technology assessement