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Review of Quantitative Finance and Accounting

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01.11.2012 | Original Research

Time-inconsistent risk preferences in a laboratory experiment

verfasst von: K. Jeremy Ko, Zhijian Huang

Erschienen in: Review of Quantitative Finance and Accounting | Ausgabe 4/2012

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Abstract

We conduct an experiment to explore the time-consistency of risk preferences in a multi-period betting game. Specifically, subjects planned their contingent betting decisions in advance then played the game dynamically later to determine whether their respective decisions matched. We find that subjects took more risk than planned in their initial bet and after losses. In addition, this increased risk was associated with an increase in breakeven mental accounting. Our findings indicate that immediacy of outcomes can lead to impulsive risk-taking behavior and highlight the importance of precommitment to long-term financial planning.

Vorheriger Artikel Erratum to: Effectiveness of copula-extreme value theory in estimating value-at-risk: empirical evidence from Asian emerging markets

Nächster Artikel Rumors and pre-announcement trading: why sell target stocks before acquisition announcements?

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Keren and Roelofsma (1995) and Onculer (2000) produce this finding for hypothetical gambles while Noussair and Wu (2006) do so with actual economic stakes.

See Thaler et al. (1997) and Gneezy and Potters (1997).

It is difficult to definitely say that behavior in the plan session is superior to that in the play session since our gambles have zero expected return. However, a large body of evidence (including the cited literature on hyperbolic preferences and myopic loss aversion) indicates that planned decisions are more consistent with long-run preferences than impulsive decisions.

We do not include a measure where subjects’ minimum wealth in the next period is at least $10 because there is no empirical evidence for such a tendency. Our measure is based on Thaler and Johnson’s finding that people exhibit greater risk-taking after losses if given a chance to recover their initial wealth.

In addition, around 5% of subjects for bets 1 and 2w and around 15% for bet 3ww bet all of their available funds. Hence, a greater proportion of subjects at the bet 3ww node are constrained by their budget than at the bet 1 and 2w nodes. We conclude, therefore, that the house money effect would be even stronger in our game without constraints.

We focus here on “betting with the house’s money”, meaning increases in dollar bets after gains. We do not focus on decreasing absolute risk-aversion as in Levy (1994) because the dollar amounts of our gambles are likely too small to impact the total wealth of subjects.

Barberis (2009) develops a prospect-theoretic model where agents voluntarily play non-positive expected return gambles even without a non-pecuniary benefit. This result comes from the fact that the probability weighting function of cumulative prospect theory combined with the optimal betting strategy places excess weight on the upper tail of the distribution.

The common ratio effect refers to the fact that most people who are indifferent between $3000 for certain and an 80% chance of $4000 would prefer an 8% chance of $4000 over a 10% chance of $3000 (Kahneman and Tversky 1979). This violation of the independence axiom of expected utility was first documented by Allais (1953).

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Titel: Time-inconsistent risk preferences in a laboratory experiment
verfasst von: K. Jeremy Ko
Zhijian Huang
Publikationsdatum: 01.11.2012
Verlag: Springer US
Erschienen in: Review of Quantitative Finance and Accounting / Ausgabe 4/2012
Print ISSN: 0924-865X
Elektronische ISSN: 1573-7179
DOI: https://doi.org/10.1007/s11156-011-0264-x

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