The Longshot Bias: Is it Risk-Love or Misperceptions

Abstract (Wharton)

The favorite-longshot bias presents a challenge for theories of decision making under uncertainty. This longstanding empirical regularity is that betting odds provide biased estimates of the probability of a horse winninglongshots are overbet, while favorites are underbet. Neoclassical explanations focus on rational gamblers who overbet long- shots due to risk-love. The competing behavioral explanations emphasize the role of misperceptions of probabilities. We provide novel empirical tests that can discriminate between these competing theories by focusing on the pricing of compound bets. We test whether the models that explain gamblers’ choices in one part of their choice set (bet- ting to win) can also rationalize decisions over a wider choice set, including compound bets in the exacta, quinella or trifecta pools. Using a new, large-scale dataset ideally suited to implement these tests we nd evidence in favor of the view that mispercep- tions of probability drive the favorite-longshot bias, as suggested by Prospect Theory. Along the way we provide more robust evidence on the favorite-longshot bias, falsifying the conventional wisdom that the bias is large enough to yield pro t opportunities (it isn’t) and that it becomes more severe in the last race (it doesn’t).

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05. March 2010 by Miguel Barbosa
Categories: Behavioral Economics, Curated Readings | Leave a comment

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