Thinking and Deciding

INVESTORS AND ENTREPRENEURS 519
ability, described in Chapter 11 (Einhorn and Hogarth, 1985). Specifically, when
probabilities are ambiguous, people imagine that they could be higher or lower, and
they adjust the probabilities by forming an average of what they imagine. As a result,
the probabilities are adjusted toward some central point, such as .5. When probabilities
are extreme (near 1 or 0), it is easier to think of ways to adjust them toward the
middle than ways to make them even more extreme.
Insurance, by its nature, deals with low-probability events. When experts disagree
about the probability of these events, or when the events are new and unfamiliar,
they are ambiguous, and people adjust them. Moreover, buyers and sellers of
insurance have different incentives to think of probabilities that are higher than what
would otherwise be the best guess. The seller must worry about having to pay for
a claim, so the seller sees the bad event (for example, a fire) as a loss. The buyer
is compensated if the bad event happens, but the premium paid is a loss. Because
losses loom larger than gains (Chapter 11), the sellers imagine more ways that a bad
event can happen, so, when the probability is ambiguous, they adjust it upward more
than the buyers do. As a result, they demand very high premiums, much higher than
expected value, whereas the buyers are willing to pay premiums that are only a little
higher than expected value. The difference means that insurance will not be sold.
The sellers, the insurers, will demand a higher price than the buyers are willing to
pay. This effect has been found in questionnaire studies (Hogarth and Kunreuther,
1989; Kunreuther, Hogarth, and Meszaros, 1993).
This effect may explain such real events as the breakdown of the market for
environmental liability insurance in the United States in the 1980s, when many
retroactive changes in the law had made the future uncertain for everyone (Huber,
1988). People felt a sense of ambiguity because the missing information about future
changes in the law was salient.
Investors and entrepreneurs
Normative theory argues that risky investments should pay a bit more than safe ones.
Declining marginal utility makes people rationally risk averse, so they will demand
greater expected return, a premium, for speculative investments. Some of this effect
will be reduced if investments can be pooled in ways that reduce the risk. A fund
made up of many different kinds of speculative investments might not itself be so
speculative if some of its components make money while others crash. So this kind
of pooling would make the expected premium smaller. It is thus a puzzle that the
premium for stocks, equities, is huge. From 1889 to 1978, the annual real rate of
return on stocks was about 7%, while it was about 1% on government bonds. (“Real”
means after taking inflation into account.) Stocks did better over the long term (thirty
years) even for people who bought stock before the 1929 stock market crash, so long
as they held their stock and did not sell. This is called the “equity premium puzzle”
(Mehra and Prescott, 1985). It is a puzzle because it cannot be explained in terms of
any plausible story about declining marginal utility.