Economics has trouble explaining why people gamble at casinos. It’s risky — with a pretty low chance of high reward. So why do people do it? A Yale finance professor has an explanation that he says also explains how people invest in the stock market.
The model — explained in detail here — relies on two basic ideas:
- Gamblers are lured in by the chance of winning a huge jackpot (from, say, a slot machine) because they don't realize just how tiny their chance of winning is.
- People walk into the casino with a plan to leave after winning or losing a certain amount of money. But they often fail to stick to the plan.
This psychological framework can be applied beyond the casino, to help explain how investors think about risk and stocks.
According to our model, then, the popularity of casinos is related to a number of stock market patterns – to the low average return on IPO stocks, for example.... The idea is that all of these phenomena are driven by the same underlying force, namely the overweighting of tails. Under this view, the same psychological mechanism that leads people to go to casinos also leads them to overpay for IPO stocks.
The "overweighting of tails" basically means that people overestimate the probability of unlikely events — in this case, winning a jackpot, or making a huge amount of money by getting in early on a new stock offering.