1. (20 points) Ariely’s main point is that we are pawns in a game whose forces we largely fail to comprehend. Indeed, we do not really learn from our mistakes. Instead we are predictability irrational. With this as background, I want you to answer the question of why do not we not learn from our mistakes better?
2. (20 points) Read Chapter 11 of the Upside of Irrationality, “Lessons from Our Irrationalities: Why We Need to Test Everything”. Then answer this question: Why are we so resistant to testing our ways of doing things? Consider the example of leeches in this chapter. Or how we teach the same material over and over again in finance even though it does not seem to work in reality. Or how Ariely found that the nurses would rip the bandages off very fast rather than test to see what worked better.
3. Read Chapter 2 of the Upside of Irrationality “The Meaning of Labor: What Legos Can Teach Us About the Joy of Work”. Then I want to answer the following questions:
A. (5 points) Why do we need so much meaning at work?
B. (5 points) Why are the economic models so wrong?
C. (10 points) What we have learned in the class is so many things in finance are not quantifiable. These include social norms, emotions, meaning, etc. Yet in finance, we love things that quantify risk like Value at Risk or mark to market accounting (which as we saw can be really flawed). Why are we so seduced by numbers and put off by qualitative things in finance and economics?
4. (20 points) There is a video on amazon called “The Inventor: Out of Blood in Silicon Valley”(you can watch on amazon or HBO but I don’t think you have to watch the entire video to understand my question). The video is about Theranos and its founder Elizabeth Holmes. You will see that so many smart people fell for Theranos and invested lots of money into the company. The same can be said for Enron, or Bernard Madoff or countless other examples. My question is why? Why are smart people so easily fooled? Use the biases we have learned in class (particularly the availability bias) to answer this question.
5. (20 points) One criticism that is levied against traditional economic and finance models is that they are often formulated as if the typical decision maker were an individual with unlimited cerebral RAM. Such a decision maker would consider all the relevant information and come up with the best choice. However, we know from this course that normal human beings are imperfect. And the information requirements for these models are totally egregious. Consider CAPM for a moment. This model assumes that investors are capable of studying the universe of securities in order to come up with all required model inputs. These inputs include expected returns and variances for all securities, as well as the co-variances among all securities. My question to you is why do we do this in finance? Why do we create models that people really cannot follow? Why do we assume people can do all these calculations? Why does assume we are so rational? Indeed, I mentioned the example of Harry Markowitz, the founder of Modern Portfolio Theory, who uses regret theory than his own modern portfolio theory to come with his allocations in his retirement portfolio.