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Degree of Randomness.
Nassim Nicholas Taleb Courant Institute of Mathematical Sciences 2nd Version, January 2004
Introduction: An agent observes his performance at different time scales. The more frequent the observation period, the greater the pain according to Prospect Theory. Clearly the model can be generalized to to all manner of emotional states on one's life. This discussion is entirely based on the Kahneman & Tversky (1979) Prospect Theory which stipulates that an agent reverts to a base-line of steady state after the process of anchoring. I take this one step further into hedonic adjustment territory. I construct an "emometer" which is a measure of emotions over a given time period. Assume that it is time additive with resetting as per Kahneman-Tversky --lets not argue now about time additivity. The Model: Consider that life's events can be quantified as a conventional Geometric Brownian Motion W0 as the initial contition, Wt the state at time t, etc. (I can use a diffusive Gaussian framework with minimal loss of generality --any fat tails more intelligent distribution with finite can produce the same naive first order result --but heavy-tailed and skewed distributions reveal another problem I discuss in Bleed v/s Blowup) V here is not utility, but the "equivalent" value function used in Kahneman-Tversky Prospect theory {see below].
T the total Using s the standard deviation of the wealth generating process, m the drift, dt the observation period, dt number of periods, W0 the initial wealth, W[t] the wealth at time t, we have for a given trajectory, the local 2 !!!!!! dt dt 2dt + dt z Emometer@dtD = T s=1 V@W@sD W@s dtDD , where W[t]=W[t-dt]
Hence Expectation of the Emometer can be summarized as !!!!!! T EAVAW@0D I1 u dt + dt zMEE Em = dt given that it is a sum of expectations
For Non Proportional Wealth the solution is simple : Assume constant trading, !!!!!! so W@tD = W@t dtD Iu dt + I dt M zM
Opening
dentist2.nb
Procedures
Prospect Theory Under Conventional Parametrization I use the Kahneman-Tversky (1992) parametrization
Plot@ V@xD . 8W0 50000, .20, .10, dt .12, .88, 2.25<, 8x, 50000, 50000<D
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dentist2.nb
The Expected emometer for the dentist, assuming he trades a constant W@tD = W@0D Hwithout much effect to such conditionL will be Emometer = T dt
i j j j j j k
!!!!!!! dt
V AW0 dt + W0
!!!!!! dt zE p@zD z +
!!!!!!! dt
V+ AW0 dt + W0
y z !!!!!! z dt zE p@zD zz z z {
1+ 1 dt 2 y zy E Hypergeometric1F1A , , Ezy z 2 2 2 2 2 {{{ Where Hupergeometirc Ha, b, cL is the Kumer Confluent Hypergeometric function : GammaA Hypergeometric1F1Ha; b; zL = HaLk HbLk zk k ! .
k =0
!!!!!! i!!! i21+ iT j i1 j 2 dt2 j j 2 dt HW0 + HW0 L L GammaA1 + E Hypergeometric1F1A 2 k k k k 2 1 3 dt y , , Ez + HW0 HW0 L L 2 2 2 2 2 {
E Hypergeometric1F1A 1+
E 2 1 dt 2 y y z z Ez Hypergeometric1F1A , , zz z 2 2 2 2 {{
dt 2 y z Ez z+ 2 2 {
Effect of the Observation Period As we see the pain drops as the observation period lengthens
dentist2.nb
Plot@Emometer@dtD . 8W0 50000, .20, .10, .88, 2.25, T 1<, 8dt, 1 252, 22 252<D
0.04
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0.08
Graphics
Extension
There exists a driftm making the emometer positive at a given scale. Some acrobatics can produce it.