1. 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

2. Talk Preview Economic Theory and Risk Taking Risk Taking: Attitude and Perception Cultural and Personality Differences How we Deal with Rare Events Conclusions

3. 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

4. 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

5. 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)

6. 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)

7. FHERS Total F 1.00.60 H.291.00.60 E.51.611.00.45 R.36.34 1.00.75 S -.07.06.04.131.00.33 DoSpeRT Subscale correlations ( Weber, Blais, Betz, 2002) Study 3

8. Hanoch, Johnson, & Wilke, Psych Science, 2006 Recreation targets bungee jumpers hang gliders scuba divers Gambling targets casino gamblers Investment targets stock-trading clubs Health targets smokers gym members

9. 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

10. 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

11. 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 19 th 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

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

13. 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

14. Perceived Risk Attitude (Weber, Blais, Betz, 2002) Domainaverseneutralseeking F44720 H45701 R43710 E49652 S50660

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

16. 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)

17. 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

18. 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)

19. 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)

20. 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

21. 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

22. 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

23. 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