Skewness is the name of the game: A note on the design of gambling games
Wiley-Blackwell Publishing, Inc.
Faculty of Business and Public Management
School of Finance and Business Economics
The von Neumann-Morgenstern theory of expected utility postulates that individuals will choose the course of actions that maximise their expected utilities. And it is only reasonable to make a decision that brings about a positive or zero expected return. Yet, what has continued to puzzle economists is that there are many incidences in gambling and investment (both involve the transfer of money among parties based on the outcome of some contingencies) where individuals have chosen actions that yield negative expected monetary returns, therefore a negative expected utility. This seemingly paradoxical behaviour has attracted much attention and effectuated many debates among academia, especially from the disciplines of economics and psychology. This paper re-examines the validity of the two arguments put forward by various economists to explain the anomaly. It is found that the skewness, not the mean or the variance of the prize distribution, attracts gamblers and investors resulting in the “irrational” behaviour mentioned above. The remainder of this paper is organised as follows: Section 2 examines the phenomenon of accepting gambles with negative expected returns. Section 3 discusses the validity of the two arguments explaining the rationality of accepting gambles with negative expected returns. Section 4 examines the findings of recent empirical studies on the anomaly. Section 5 discusses the implications of the love of skewness on the optimal design of gambles. Section 6 is the conclusion.