Your Risk Attitude, Your Investments, & Your Taste for Luxury

Abstract (Via U Penn)

Nudging people to make good investments is necessary because of low financial literacy. One type of advice concerns allocation to risky vs. safe investments. Financial advisors generally assume that people differ in their risk attitudes, and they sometimes try to assess these attitudes with questionnaires about risks. But attitudes toward risks are influenced by many factors that are irrelevant to ultimate outcomes. Arguably, what is important is the utility of money. Some people are satisfied with a no-frills retirement, while others hanker after travel, yachts, and large legacies. It is the latter group who would do well to take risks, as their utility for money is less concave, more linear. I report a questionnaire study in which questions about risk itself were uncorrelated with questions about the utility of money and the taste for luxuries, which were correlated in reasonable ways with each other.

Introduction (via Upenn)

People have trouble with investments for retirement (Benartzi & Thaler, 2007). Many have made bad decisions that led to the loss of their savings, such as putting their pension fund into the stock of their employer. Most people save too little. That is, the gain in expected utility in their later years from additional saving would exceed the loss in their earlier years. Young people are sometimes too risk-averse. For example, they invest too little in stocks relative to fixed-income investments. On the other hand, people are too risk-seeking to the extent to which they fail to diversify.

Paternalistic regulation may be warranted for some of these examples. Regulations should, and often do, discourage company stock for pension funds, encourage saving, and encourage diversification. Paternalistic measures may be warranted by thinking of a person in the future as a somewhat different person, whose well-being may be neglected by the current person who inhabits (roughly) the same body. The future person would be upset at the current person’s failure to provide (Parfit, 1984). The state may intervene to protect the interests of that future person, just as it protects the interests of current people against the neglect of their contemporaries.

My concern here, though is with risk attitude, particularly the component that results from different tastes. Inthis case, it is difficult to adopt a general paternalistic prescription. Here, regulation may be best achieved through a “libertarian paternalist” approach (Thaler & Sunstein, 2008), which gives people freedom while “nudging” them toward options that would benefit most people.

Findings (via Upenn)

The results suggest two conclusions. First, asking people directly about their risk preferences may fail to maximize their expected utility. In particular, some people may have substantial utility for luxuries, so that they ought to be willing to take risks in hopes of being able to afford those luxuries. Other people have no use for luxuries and have no conflict with the single goal of trying to insure a no-frills retirement. These two extreme types do not seem to be differentiated by their risk attitude. But if we ask them about their utility for money using a method of comparing differences, the results do reflect their different tastes.

Second, and relatedly, people differ more in their tastes for luxuries, and consequently also in what should be their willingness to take risks for a higher income, then they differ in risk preferences themselves. Thus, a one-size-fits-all approach to retirement planning is unlikely to maximize expected utility.

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

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