Tuesday, 14 June 2016

Brexiteers and Risk

Here's a quick post about a story that caught my eye.  Apparently Nigel Farage has placed a £1,000 bet on Britain voting to leave the European Union.  Let's assume that Nigel Farage wants the UK to leave the EU, then this tells us something about the man and his attitude to risk.

Suppose I offered you the following two options.  Option 1: I toss a fair coin, if it comes up Heads, you pay me £10,000; but if it comes up Tails, I pay you £11,000.  Option 2, I just give you £450.  Most people, if they are honest, would probably choose option 2.  But on average, Option 1 is worth £500.  If you are honest with yourself and choose option 2, then you are risk averse.

Economists usually assume that individual agents are risk averse.  In other words we don't like risk, and, where possible, we would pay someone else to take on our risks for us.  That's why there are companies that sell insurance.  Insurance policies pay out sums of money in states of the world where certain events have happened, such as our house being robbed, or our car being damaged in an accident.  In that way, betting markets, which bet on events happening or not happening are actually a lot like insurance policies.

So how would a risk averse individual approach betting on the EU referendum given that they have a preference the result should go one way or the other.  If someone really wants to see the UK vote to leave the EU, they should actually bet on the UK voting to stay in.  That way, they narrow the set of possible outcomes in terms of how happy they are at the result.  Their elation at Britain voting to leave would be a little muted by having lost a bit of money, but their disappointment at Britain voting to stay would be compensated by having won some money.

For die hard proponents of either remain or leave, it may well be the case that even bets of £1,000 don't provide stakes high enough to provide full insurance (ensuring they are just as happy in either event), but they must be able to use betting markets to provide some insurance.

So what does it tell us about an individual if they bet £1,000 on their preferred outcome, thus widening the outcomes and exposing themselves to more risk.  It could be that they perceive the odds are very favourable, and so they take on more risk for what they perceive as a much higher expected level of wealth.  However an individual should be aware of and correct for their own optimism bias.

The other possibility, and this seems somewhat more likely, is that they are not risk averse as most people are believed to be, but risk loving.  They enjoy risk and the shot of adrenaline they get as they wait to see if their horse crosses the line first.  The wider the risk, the greater the adrenaline hit and the more fun it all seems to be!

I'll be the first to admit that people like this can be fun to hang around, but I just have one more question for you: How much of your money are you willing to trust them with?  Because a vote for Brexit is a vote to trust some highly risk loving people with all of our money and all of our futures for generations to come.

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