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Bernoulli in the year 1738 published an example, the problem being presented to him
by his cousin Nicolas Bernoulli which is popularly referred as `The St. Petersburg
Paradox' (Tobragel, 2003). The paradox deals with a `Lottery game' representing a blend of
concepts of probability and that of decision theory.
Knut (2001) has advocated that Bernoulli's theory in modern terms clearly
implies steady relative risk abhorrence and that the value of anything must not be based on
price but the utility it gains. Hence, in order to arrive at a `correct' investment strategy, a person has to
perform optimization on a non-linear stochastic function, but this is hardly the way
anyone invests. To this logic, purists may resort to the argument that this is the `correct' way
to invest and those who do not do so are naïve, `unscientific' and `incorrect'.
However, the stock market game is unique in the sense that an investor's strategy
bears results only when assumptions about other investor's strategy hold good. Thaler
(1999) examined a simplified two-security market with two kinds of investors called
rational (who use optimization techniques on stochastic non-linear functions) and quasi (who
do not). He finds that the market will behave according to the rationals only when
five conditions are met, such as:
(1) The ratio of quasi/rational (in terms of money
invested) should not be high; (2) transaction cost of `short sell' should be negligible; (3)
quasi-investor are not allowed to `short sell'; (4) at some point of time, true values of
the securities are realized by all; and (5) the rationales have sufficient resources to wait
till that period and be in the market. |
