In my post Can You Time the Market?, I used a coin that was weighted 60/40 as an analogy for the stock market. I took for granted that any rational person would always choose Heads if the odds were 60/40 in Heads’ favor. I was wrong.
In Hersh Shefrin’s book “Beyond Greed and Fear – Understanding Behavioral Finance and the Psychology of Investing” he conducts a study on his MBA students. Using a fair coin, he gives them $1 for each correct prediction and nothing for each wrong prediction.
“When I play this version of the game in MBA classes, students’ predictions usually feature about fifty percent heads and fifty percent tails, in accordance with what they imagine randomness to have produced. Then we play a second version, where the coin is a little worn on one side, thereby changing the odds slightly: I tell them that the probability of heads has increased from 50 percent to 51 percent. When I ask how people would change their prediction patterns, most say that they might change one or two of their tails to heads, but nothing more. Then I ask how people would change their prediction pattern if the probability of heads moved from 51 percent to 55 percent. Most change a few more tails to heads. But is this the right way to predict?”
It should be bafflingly obvious that if presented with a weighted coin, you should always predict the weighted side. Could you even image doing otherwise? When faced with either predicting an outcome that was 55% likely or 45% likely, the MBA students sometimes chose the outcome that was 45% likely. I can’t explain it.
“The optimal prediction pattern for all version of this game is to [i]predict heads every time[/i]. This surprises more people, because their instincts are to make their prediction representative of the process they are trying to predict.”
All I can say is that I’m glad I don’t have their lousy instincts. I have my own lousy instincts! I say that because I’ve certainly gotten my fair share of behavioral finance questions wrong before.
Written in 2015.
2023 Update: Apparently, a microcosm humility came later in my life.