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When people buy stocks, they tend to have beliefs in place about how well the investments will perform and which ones are riskier bets. Economists would love to know what is going on in people's minds, but because that is not always possible, they instead come up with models to predict how people will behave. The models are acting as if people have certain beliefs in mind.
The most popular theory of this sort, called the subjective expected utility theory, or SEU, models people's behaviors in making financial choices under uncertain circumstances. The theory holds that a person trying to decide between two stocks, say IBM and Google, behaves as if they have subjective beliefs about how risky investments are to them personally as well as about the probability that one stock will do better than the other.
Analysts - People - Minds - Behavior - Choices
"As analysts, we can't measure what is in people's minds but we can model their behavior. We can look at the choices they make," says Federico Echenique, the Allen and Lenabelle Davis Professor of Economics. "For instance, if somebody buys orange juice then we presume they like orange juice. A preference is meaningful if I can set up a choice experiment in which I allow someone to choose between one item and another, and they choose one item. To us economists, preference means choice."
Echenique, with Caltech professor of economics Kota Saito and other colleagues, has been busy taking a closer look at the SEU theory and related models over the past several years. In 2015 and 2016, the researchers published theoretical work proposing new mathematical tools to test whether behavior is consistent with the SEU theory. A core assumption of SEU is that individuals will buy less when prices are higher. Nonetheless, researchers have had a hard time validating that condition in data derived...
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