Time Varying Risk Aversion
TL;DR: In this paper, the authors used a repeated survey of an Italian bank's clients to test whether investors' risk aversion increases following the 2008 financial crisis and found that both a qualitative and a quantitative measure of risk aversion increased substantially after the crisis.
Abstract: We use a repeated survey of an Italian bank’s clients to test whether investors’ risk aversion increases following the 2008 financial crisis. We find that both a qualitative and a quantitative measure of risk aversion increases substantially after the crisis. After considering standard explanations, we investigate whether this increase might be an emotional response (fear) triggered by a scary experience. To show the plausibility of this conjecture, we conduct a lab experiment. We find that subjects who watched a horror movie have a certainty equivalent that is 27% lower than the ones who did not, supporting the fear-based explanation. Finally, we test the fear-based model with actual trading behavior and find consistent evidence.
Citations
More filters
TL;DR: Evidence indicates that poverty causes stress and negative affective states which in turn may lead to short-sighted and risk-averse decision-making, possibly by limiting attention and favoring habitual behaviors at the expense of goal-directed ones, which may constitute a feedback loop that contributes to the perpetuation of poverty.
Abstract: Poverty remains one of the most pressing problems facing the world; the mechanisms through which poverty arises and perpetuates itself, however, are not well understood. Here, we examine the evidence for the hypothesis that poverty may have particular psychological consequences that can lead to economic behaviors that make it difficult to escape poverty. The evidence indicates that poverty causes stress and negative affective states which in turn may lead to short-sighted and risk-averse decision-making, possibly by limiting attention and favoring habitual behaviors at the expense of goal-directed ones. Together, these relationships may constitute a feedback loop that contributes to the perpetuation of poverty. We conclude by pointing toward specific gaps in our knowledge and outlining poverty alleviation programs that this mechanism suggests.
1,049 citations
TL;DR: Gneezy et al. as discussed by the authors conducted a meta-analysis of the relationship of financial literacy and of financial education to financial behaviors in 168 papers covering 201 prior studies, and found that interventions to improve financial literacy explain only 0.1% of the variance in financial behaviors studied, with weaker effects in low-income samples.
Abstract: Policy makers have embraced financial education as a necessary antidote to the increasing complexity of consumers' financial decisions over the last generation. We conduct a meta-analysis of the relationship of financial literacy and of financial education to financial behaviors in 168 papers covering 201 prior studies. We find that interventions to improve financial literacy explain only 0.1% of the variance in financial behaviors studied, with weaker effects in low-income samples. Like other education, financial education decays over time; even large interventions with many hours of instruction have negligible effects on behavior 20 months or more from the time of intervention. Correlational studies that measure financial literacy find stronger associations with financial behaviors. We conduct three empirical studies, and we find that the partial effects of financial literacy diminish dramatically when one controls for psychological traits that have been omitted in prior research or when one uses an instrument for financial literacy to control for omitted variables. Financial education as studied to date has serious limitations that have been masked by the apparently larger effects in correlational studies. We envisage a reduced role for financial education that is not elaborated or acted upon soon afterward. We suggest a real but narrower role for “just-in-time” financial education tied to specific behaviors it intends to help. We conclude with a discussion of the characteristics of behaviors that might affect the policy maker's mix of financial education, choice architecture, and regulation as tools to help consumer financial behavior.
This paper was accepted by Uri Gneezy, behavioral economics.
948 citations
Posted Content•
TL;DR: A meta-analysis of the relationship of financial literacy and of financial education to financial behaviors in 168 papers covering 201 prior studies finds that interventions to improve financial literacy explain only 0.1% of the variance in financial behaviors studied, with weaker effects in low-income samples.
Abstract: Policy makers have embraced financial education as a necessary antidote to the increasing complexity of consumers’ financial decisions over the last generation. We conduct a meta-analysis of the relationship of financial literacy and of financial education to financial behaviors in 168 papers covering 201 prior studies. We find that interventions to improve financial literacy explain only 0.1% of the variance in financial behaviors studied, with weaker effects in low-income samples. Like other education, financial education decays over time; even large interventions with many hours of instruction have negligible effects on behavior 20 months or more from the time of intervention. Correlational studies that measure financial literacy find stronger associations with financial behaviors. We conduct three empirical studies and we find that the partial effects of financial literacy diminish dramatically when one controls for psychological traits that have been omitted in prior research or when one uses an instrument for financial literacy to control for omitted variables. Financial education as studied to date has serious limitations that have been masked by the apparently larger effects in correlational studies. We envisage a reduced role for financial education that is not elaborated or acted upon soon afterward. We suggest a real but narrower role for “just in time” financial education tied to specific behaviors it intends to help. We conclude with a discussion of the characteristics of behaviors that might affect the policy maker’s mix of financial education, choice architecture, and regulation as tools to help consumer financial behavior.
835 citations
TL;DR: The authors show that there is a non-monotonic relation between the intensity of CEOs' early-life exposure to fatal disasters and corporate risk-taking, and that the link between CEOs' disaster experience and corporate policies has real economic consequences on firm riskiness and cost of capital.
Abstract: The literature on managerial style posits a linear relation between a CEO’s past experiences and firm risk. We show that there is a non-monotonic relation between the intensity of CEOs’ early-life exposure to fatal disasters and corporate risk-taking. CEOs who experience fatal disasters without extremely negative consequences lead firms that behave more aggressively, whereas CEOs who witness the extreme downside of disasters behave more conservatively. These patterns manifest across various corporate policies including leverage, cash holdings, and acquisition activity. Ultimately, the link between CEOs’ disaster experience and corporate policies has real economic consequences on firm riskiness and cost of capital.
386 citations
TL;DR: In this paper, the authors circumvent the control problems by priming financial professionals with either a boom or a bust scenario and by subsequently measuring their risk aversion in two experimental investment tasks with real monetary stakes.
Abstract: A key ingredient of many popular asset pricing models is that investors exhibit countercyclical risk aversion, which helps explain major economic puzzles such as the strong and systematic variation in risk premiums over time and the high volatility of asset prices. There is, however, surprisingly little evidence for this assumption because it is difficult to control for the host of factors that change simultaneously during financial booms and busts. We circumvent these control problems by priming financial professionals with either a boom or a bust scenario and by subsequently measuring their risk aversion in two experimental investment tasks with real monetary stakes. Subjects who were primed with a financial bust were substantially more risk averse than those who were primed with a boom. Subjects were also more fearful in the bust than in the boom condition, and their fear is negatively related to investments in the risky asset, suggesting that fear may play an important role in countercyclical risk aversion. The mechanism described in this paper is relevant for theory and has important implications, as it provides the basis for a self-reinforcing process that amplifies market dynamics.
327 citations
References
More filters
TL;DR: In this article, the authors present a simple overlapping generations model of an asset market in which irrational noise traders with erroneous stochastic beliefs both affect prices and earn higher expected returns.
Abstract: We present a simple overlapping generations model of an asset market in which irrational noise traders with erroneous stochastic beliefs both affect prices and earn higher expected returns. The unpredictability of noise traders' beliefs creates a risk in the price of the asset that deters rational arbitrageurs from aggressively betting against them. As a result, prices can diverge significantly from fundamental values even in the absence of fundamental risk. Moreover, bearing a disproportionate amount of risk that they themselves create enables noise traders to earn a higher expected return than rational investors do. The model sheds light on a number of financial anomalies, including the excess volatility of asset prices, the mean reversion of stock returns, the underpricing of closed-end mutual funds, and the Mehra-Prescott equity premium puzzle.
5,703 citations
TL;DR: In this paper, the combined problem of optimal portfolio selection and consumption rules for an individual in a continuous-time model was examined, where his income is generated by returns on assets and these returns or instantaneous "growth rates" are stochastic.
Abstract: OST models of portfolio selection have M been one-period models. I examine the combined problem of optimal portfolio selection and consumption rules for an individual in a continuous-time model whzere his income is generated by returns on assets and these returns or instantaneous "growth rates" are stochastic. P. A. Samuelson has developed a similar model in discrete-time for more general probability distributions in a companion paper [8]. I derive the optimality equations for a multiasset problem when the rate of returns are generated by a Wiener Brownian-motion process. A particular case examined in detail is the two-asset model with constant relative riskaversion or iso-elastic marginal utility. An explicit solution is also found for the case of constant absolute risk-aversion. The general technique employed can be used to examine a wide class of intertemporal economic problems under uncertainty. In addition to the Samuelson paper [8], there is the multi-period analysis of Tobin [9]. Phelps [6] has a model used to determine the optimal consumption rule for a multi-period example where income is partly generated by an asset with an uncertain return. Mirrless [5] has developed a continuous-time optimal consumption model of the neoclassical type with technical progress a random variable.
4,908 citations
Posted Content•
[...]
TL;DR: It is shown that emotional reactions to risky situations often diverge from cognitive assessments of those risks, and when such divergence occurs, emotional reactions often drive behavior.
Abstract: Virtually all current theories of choice under risk or uncertainty are cognitive and consequentialist. They assume that people assess the desirability and likelihood of possible outcomes of choice alternatives and integrate this information through some type of expectation-based calculus to arrive at decision. The authors propose an alternative theoretical perspective, the risk-as-feelings hypothesis, that highlights the role of affect experienced at the moment of decision making. Drawing on research from clinical, physiological, and other subfield of psychology, they show that emotional reactions to risky situations often drive behavior. The risk-as-feelings hypothesis is shown to explain a wide range of phenomena that have resisted interpretation in cognitive-consequentialist terms.
4,901 citations
TL;DR: This paper reviewed the literature on gender differences in economic experiments and identified robust differences in risk preferences, social (other-regarding) preferences, and competitive preferences, speculating on the source of these differences and their implications.
Abstract: This paper reviews the literature on gender differences in economic experiments. In the three main sections, we identify robust differences in risk preferences, social (other-regarding) preferences, and competitive preferences. We also speculate on the source of these differences, as well as on their implications. Our hope is that this article will serve as a resource for those seeking to understand gender differences and to use as a starting point to illuminate the debate on gender-specific outcomes in the labor and goods markets.
4,864 citations
TL;DR: In this article, a menu of paired lottery choices is structured so that the crossover point to the high-risk lottery can be used to infer the degree of risk aversion, and a hybrid "power/expo" utility function with increasing relative and decreasing absolute risk aversion is presented.
Abstract: A menu of paired lottery choices is structured so that the crossover point to the high-risk lottery can be used to infer the degree of risk aversion With normal laboratory payoffs of several dollars, most subjects are risk averse and few are risk loving Scaling up all payoffs by factors of twenty, fifty, and ninety makes little difference when the high payoffs are hypothetical In contrast, subjects become sharply more risk averse when the high payoffs are actually paid in cash A hybrid "power/expo" utility function with increasing relative and decreasing absolute risk aversion nicely replicates the data patterns over this range of payoffs from several dollars to several hundred dollars
4,687 citations