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Ulric B. and Evelyn L. Bray Social Sciences Seminar

Tuesday, October 18, 2022
4:00pm to 5:00pm
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Baxter Lecture Hall
Simplicity, Risk, and Financial Choice
Indira Puri, PhD Candidate, Department of Economics, MIT,

Abstract: I introduce simplicity preferences in choice under risk, run theoretically-motivated experiments that show that canonical models cannot fully capture simplicity-seeking behavior, and finally show that investors choose binary options that are dominated under standard preferences but provide higher utility under simplicity theory. Formalizing the theory axiomatically, I experimentally find that participants satisfy its characterizing axiom. I also show that standard methods of estimating risk aversion conflate risk and complexity; dominance violations occur more frequently as complexity increases; and complexity aversion is heterogeneous in cognitive ability. The experiments are structured to separate this simplicity-seeking behavior from choice driven by cumulative prospect theory, prospect theory, rational inattention, sparsity, salience, or complexity-varying probability weights, among other canonical models and extensions. A second paper shows that in retail financial markets focused on binary options, higher prices for dominated simple products cannot be captured by prospect theory, loss aversion, ambiguity aversion, implicit or explicit trading costs, noise trading, or liquidity premia, but are consistent with simplicity preferences on the part of retail investors.

For more information, please contact Barbara Estrada by phone at 626-395-4083 or by email at [email protected].