Determinants of Risk Taking:The Important Role of Risk Perception

Elke U. Weber

Columbia Business School

and Center for the Decision Sciences

SAMSI Presentation, October 4, 2007

Talk Preview

Economic Theory and Risk Taking

Risk Taking: Attitude and Perception

Cultural and Personality Differences

How we Deal with Rare Events

Conclusions

What does economic theory/finance tell us about the determinants of risk taking?

Traditional economics/finance models Expected Utility (EU) theory Risk-return models, like CAPM

Risk is an (invariant) attribute of the risky (investment) option

Risk Attitude/Risk Tolerance is the only thing presumed to vary between individuals

Risk Attitude/Risk Tolerance as a Personality Trait

While technically only a parameter of a utility function, risk attitudes are often given interpretations as personality traits

Psychometric scales measure degree of risk-aversion/risk-seeking (Kogan & Wallach, 1962)

Risk-attitude used as a selection criterion in some hiring decisions or client/advisor matchings

Problem with Risk Attitude as a Personality Trait

Risk taking of any given individual varies across contexts and situations

Anecdotal evidence manager who is risk neutral with company money, but

risk averse in her personal financial decisions rock climber who takes plenty of recreational risks but is

anxious about missing flights Systematic comparison of risk taking financial,

health, recreational, ethical or social decisions (Weber, Blais, Betz, 2002)

DoSpeRT Items (Weber, Blais, Betz, 2002)

Admitting that your tastes are different from those of a friend. (S)

Going camping in the wilderness. (R)

Betting a day’s income at the horse races. (I)

Swimming far out from shore on an unguarded lake or ocean. (R)

Investing 10% of your annual income in a moderate growth mutual fund. (I)

Not wearing a seat belt when being a passenger in the front seat. (H)

Taking some questionable deductions on your income tax return. (E)

Disagreeing with an authority figure on a major issue. (S)

F H E R S Total

F 1.00 .60

H .29 1.00 .60

E .51 .61 1.00 .45

R .36 .34 .34 1.00 .75

S -.07 .06 .04 .13 1.00 .33

DoSpeRT Subscale correlations (Weber, Blais, Betz, 2002)

Study 3

Hanoch, Johnson, & Wilke, Psych Science, 2006

Recreation targetsbungee jumpershang glidersscuba divers

Gambling targetscasino gamblers

Investment targetsstock-trading clubs

Health targetssmokers

gym members

Problem with single determinant (parameter) for risk preference

Need to account for both situational and chronic/biological differences in risk taking

Age and gender differences in sensation seeking

Hard to do so with a single parameter Is risk attitude really the only determinant of risk taking that

varies between individuals or situations?

Behavioral models of risk taking add determinants Prospect Theory

Adds loss aversion and probability weighting Generalize risk-return models (Weber & Milliman, Mgt Sci,

1997) Perceived riskiness of risky choice options seen as a psychological

variable

Risk Perception as Mediator of Situational Differences

Perception is subjective and varies with Expected outcome volatility Goals, expectations, and other reference points Familiarity with risky option and perceived

control Home bias effects in investing mediated by differences in

perceived riskiness (Kilka & M. Weber, 2000; Weber et al., 2005) Other affective responses (dread and fear)

Risk as a feeling (Loewenstein, Weber, Hsee, & Welch, 2001) Personal experience of adverse consequences

Risk Perception as Mediator of Situational Differences

Perception is relative Thurber story Two thought experiments

buckets of water two inheritances

Also true of perceptions of difference/volatility Weber’s law from 19th century psychophysics

difference in magnitude required to perceive two stimuli as different (JND) is proportional to absolute stimulus magnitude

Coefficient of variation (CV) as a measure of perceived volatility CV = standard deviation / expected value

measure of relative risk: risk per unit of return Used in many applied areas

engineering, medicine, agricultural economics

Relative-risk coefficient of variation predicts risky foraging behavior of animals across a range of situations(S. Shafir, 2000)

Risk taking

Distinguish between Perception

Evaluation of outcomes and probabilities (hot or cold) Motivation

Whether risk as perceived is exciting or scary Probably related to optimum arousal set points

Sensation seeking (Zuckerman)

Perceived-risk attitude (PRA), b:

Willingness to take(X) = a(Benefit(X)) + b(Perceived Risk(X)) + c

Perceived Risk Attitude (Weber, Blais, Betz, 2002)

Domain averse neutral seeking

F 44 72 0

H 45 70 1

R 43 71 0

E 49 65 2

S 50 66 0

Some effects attributed to “risk attitude” due to non-attitudinal factors Perceptions of risk (and of return) Probability weighting Loss aversion

Cultural Differences in Risk Taking Mediated by Differences in Perceived Riskiness

Study of investment decisions made by Chicago and Shanghai business students, where Chinese appeared less risk averse than Americans Chinese had greater WTP for same investment options

“Cushion” hypothesis Cultural collectivism provides implicit insurance against catastrophic

losses, so risks are objectively reduced Investors with larger “collectivist” networks (mostly Chinese)

perceived risks of investment options to be lower Risk perceptions and risk taking only different between cultures for

outcome dimensions that are transferable For money, but not for health or grades

No cultural differences in attitude towards perceived risk, b WTP(X) = EV(X) – bR(X), where R(X) is stated subjective

perceived risk of investment option X, not Var(X)

Not all differences in perceived riskiness are “rational”/justifiable

Gender differences in risk taking Women’s pension investments are more

conservative than those of men Women take fewer risks than men in all

domains, except for social risks But also perceive the risks to be greater in those

domains than men do (Weber, Blais, Betz, 2002) No gender differences in perceived risk attitude

Gender differences in perceived risk

Probably not biological, since restricted to cultural majorities White males perceive risks to be lower than any other

group (Flynn et al., 1994) Sociological/psychological explanation for group

differences in perceived risk Majority members do not “take risks,” they have the power to

“manage risks” Perceived controllability one of the psychological risk

dimensions identified by Slovic et al. in 1960s and 70s Driving seen as safer than flying

Emotional mediation of effect Responsible for false generalization to domains where no

gender differences in controllability exist (investment decisions)

Risk taking in decisions from description vs. decisions from experience

Decisions from Description outcome distribution fully described

numerically or graphically almost exclusively studied in human choice

Weber, Shafir, Blais (2004)

Decisions from Experience outcome distribution initially unknown

knowledge of outcome distribution acquired by personal exposure in repeated choices

strong recency in effect of prior observations exclusively studied in animal choice

recent resurgence of interest in reinforcement learning models Camerer & Ho (1999), March (1996)

Effect of rare events

Rare events are Overweighted in decisions from description

Captured by decision weight function of Prospect Theory Underweighted in decisions from experience

Unless they recently occurred, in which case they are strongly overweighted (Hertwig et al., 2004)

Risk taking under the two information conditions can be very different as a result, when outcome distributions are skewed

Most investment decisions based on a combination of outcome distribution description and personal experience Personal experience typically the stronger determinant of choice

More emotionally engaging, vivid

Decomposing risk taking into risk perception and risk attitude: What does it buy us? Improved understanding of individual or group

differences in risk taking Not all differences in risk taking are due to differences in

attitude towards risk (liking it or disliking it), though some are

Probably related to biological differences in optimal arousal set points

Differences in perceived risk can be due to Stable differences in sociocultural environment Transient situational characteristics

Differences in perceived risk can be Justifiable and realistic responses to differences in opportunities or

constraints Less justifiable myopic emotional reactions to events or emotional

overgeneralizations

Summary

Talk tried to introduce you to a different perspective on risk taking (in financial and other contexts) “Psychology” component of risk taking is not

restricted to individual or group differences in risk attitude

Richer framework that unconfounds differences in risk perception from differences in true attitude towards risk resolves many apparent paradoxes

Inconsistent risk attitudes across domains Rabin’s (2000) calibration theorem

Possible Take Away

Better appreciation of the influence of non-analytic processes on risky decisions

Better appreciation of the malleability of perceptions of risk Risk is not an immutable attribute of a risky choice

option Mode by which information about outcome

variability is acquired, familiarity and emotional comfort, and expectations and other relative comparisons can play important roles