Ignorance and Indifference: Decision-Making in the Lab and in the Market

35 Pages Posted: 7 Jun 2019

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Date Written: May 8, 2019

Abstract

Economic agents face an evolving, non-ergodic environment. The corresponding permanently undersampled “population” distribution naturally permits unseen, rare events. The principle of indifference, implemented via the methods of parameterization invariance and/or maximum entropy, provides a disciplined, rational approach to learning, inference and decision in this underinformed setting. Canonical economic problems of choice under uncertainty from both the micro (binary lotteries) and macro (consumption-investment) domains can be formulated in terms of dynamic online learning, with new gambles and new regimes regularly arising. Accordingly, Bayesian updating under invariant ignorance priors allows to reverse-engineer and rationalize, in a mutually consistent way, the Allais paradox/prospect theory’s probability distortions identified in laboratory experiments, as well as the equity premium/risk-free rate, non-monotone pricing kernel and portfolio underdiversification puzzles observed in financial markets.

Suggested Citation

Verstyuk, Sergiy, Ignorance and Indifference: Decision-Making in the Lab and in the Market (May 8, 2019). Available at SSRN: https://ssrn.com/abstract=3391573 or http://dx.doi.org/10.2139/ssrn.3391573

Sergiy Verstyuk (Contact Author)

Harvard University ( email )

1875 Cambridge Street
Cambridge, MA 02138
United States

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