Risk off

RISK has always had a bit of an image problem. It is associated in the popular mind with gamblers, skydivers and, more recently, the overpaid bankers who crippled the global economy. Yet long-term economic growth would be impossible without people willing to wager all they have by starting a business, expanding an existing one or trying to invent a better mousetrap. Such risk-taking has been disturbingly scarce in America of late: the number of self-employed workers, job-creation at start-ups and the sums invested in businesses have been low.

Though changing appetites for risk are central to booms and busts, economists have found it hard to explain their determinants. Instead, they tend to cite John Maynard Keynes’s catchy but uncrunchy talk of “animal spirits”. Recent advances in behavioural economics, however, are changing that.

Economists have long known that people are risk-averse: Daniel Bernoulli, a Swiss mathematician, observed as much in the 18th century. Consider this simple test: given the choice, would you prefer a gift of $50, or to play a game with a 50% chance of winning $120? It might seem logical to pick the second, since the average pay-off—$60—is bigger. In practice, most people choose the first, preferring a small but certain payment to a larger but uncertain one.

Yet the willingness to run risks varies enormously among individuals and over time. At least some of this variation is inherited. One study of twins in Sweden found that identical ones had a closer propensity to invest in shares than fraternal ones, implying that genetics explains a third of the difference in risk-taking.

Upbringing, environment and experience also play a part. Research consistently finds, for example, that the educated and the rich are more daring financially. So are men, but apparently not for genetic reasons. Alison Booth of Australian National University and Patrick Nolen of the University of Essex found that teenage girls at single-sex schools were less risk-averse than those at co-ed schools, which they think may be due to the absence of “culturally driven norms and beliefs about the appropriate mode of female behaviour”.

People’s financial history has a strong impact on their taste for risk. Looking at surveys of American household finances from 1960 to 2007, Ulrike Malmendier of the University of California at Berkeley and Stefan Nagel, now at the University of Michigan, found that people who experienced high returns on the stockmarket earlier in life were, years later, likelier to report a higher tolerance for risk, to own shares and to invest a bigger slice of their assets in shares.

But exposure to economic turmoil appears to dampen people’s appetite for risk irrespective of their personal financial losses. That is the conclusion of a paper by Samuli Knüpfer of London Business School and two co-authors. In the early 1990s a severe recession caused Finland’s GDP to sink by 10% and unemployment to soar from 3% to 16%. Using detailed data on tax, unemployment and military conscription, the authors were able to analyse the investment choices of those affected by Finland’s “Great Depression”. Controlling for age, education, gender and marital status, they found that those in occupations, industries and regions hit harder by unemployment were less likely to own stocks a decade later. Individuals’ personal misfortunes, however, could explain at most half of the variation in stock ownership, the authors reckon. They attribute the remainder to “changes in beliefs and preferences” that are not easily measured.

This seems consistent with a growing body of research that links a low tolerance of risk to past emotional trauma. Studies have found, for example, that natural disasters such as the tsunami that hit South-East Asia in 2004 and military conflicts such as the Korean war can render their victims more cautious for years.

The same seems to be true for financial trauma. Luigi Guiso of the Einaudi Institute for Economics and Finance and two co-authors examined the investments of several hundred clients of a large Italian bank in 2007 and again in 2009 (ie, before and after the plunge in global stockmarkets). The authors also asked the clients about their attitudes towards risk and got them to play a game modelled on a television show in which they could either pocket a small but guaranteed prize or gamble on winning a bigger one. Risk aversion, by these measures, rose sharply after the crash, even among investors who had suffered no losses in the stockmarket. The reaction to the financial crisis, the authors conclude, looked less like a proportionate response to the losses suffered and “more like old-fashioned ‘panic’.”

Horror story

The authors’ conclusions were reinforced by a separate test administered to a few hundred university students. About half were asked to watch a five-minute excerpt of a gruesome torture scene from a horror film. Then, the entire group answered the same questions about risk as the Italian bank’s clients. Watching the horror movie increased the students’ aversion to risk by roughly as much as the financial crisis had chastened the bank’s clients, although not among those who claimed to like horror movies.

These studies suggest that the sweep and severity of the recent slumps in America and Europe will scar a wide range of people, not just those who lost money in the markets. The financial crisis is likely to inhibit them from taking the sort of risks that help propel the economy for decades to to come. Regulators and policymakers may soon be worrying about the lack of risk-takers, not fretting about their excesses.

_Sources

_{“Nature or Nurture: What Determines Investor Behavior?” by Amir Barnea, Henrik Cronqvist, and Stephan Siegel, Journal of Financial Economics, 2010}

_{“Gender Differences in Risk Behaviour: Does Nurture Matter?” by Alison Booth and Patrick Nolen, The Economic Journal, February 2012}

_{“Depression Babies: Do Macroeconomic Experiences Affect Risk-Taking?” by Ulrike Malmendier and Stefan Nagel, Quarterly Journal of Economics, 2011}

_{“Labor Market Experiences and Portfolio Choice: Evidence from the Finnish Great Depression” by Samuli Knüpfer, London Business School; and Elias Rantapuska and Matti Sarvimäki, Aalto University, working paper, December 2013}

_{“Trust, Risk, and Time Preferences After a Natural Disaster: Experimental Evidence from Thailand” by Alessandra Cassar and Carl von Kessler, University of San Francisco; and Andrew Healy, Loyola Marymount University, working paper, 2011}

_{“The Long-Run Impact of Traumatic Experience on Risk Aversion” by Young-Il Kim and Jungmin Lee, Sogang University, South Korea, working paper, July 2013}

_{“Time Varying Risk Aversion” by Luigi Guiso, Einaudi Institute for Economics and Finance, Italy; Paola Sapienza, Northwestern University; and Luigi Zingales, University of Chicago, National Bureau of Economic Research Working Paper, August 2013}

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