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History-Dependent Risk Attitude

  • David Dillenberger

    ()

    (Department of Economics, University of Pennsylvania)

  • Kareen Rozen

    ()

    (Department of Economics, Yale University and Cowles Foundation for Research in Economics)

We propose a model of history-dependent risk attitude (HDRA), allowing the attitude of a decision-maker (DM) towards risk at each stage of a T-stage lottery to evolve as a function of his history of disappointments and elations in prior stages. We establish an equivalence between the existence of an HDRA representation and two documented cognitive biases. First, the DM’s risk attitudes are reinforced by prior experiences: he becomes more risk averse after suffering a disappointment and less risk averse after being elated. Second, the DM displays a primacy effect: early outcomes have the strongest effect on risk attitude. Furthermore, the DM lowers his threshold for elation after a disappointing outcome and raises it after an elating outcome; this makes disappointment more likely after elation and vice-versa, leading to statistically reversing risk attitudes. “Gray areas” in the elation-disappointment assignment are connected to optimism and pessimism in determining endogenous reference points.

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File URL: http://economics.sas.upenn.edu/system/files/working-papers/11-004.pdf
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Paper provided by Penn Institute for Economic Research, Department of Economics, University of Pennsylvania in its series PIER Working Paper Archive with number 11-004.

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Length: 39 pages
Date of creation: 14 Feb 2011
Date of revision:
Handle: RePEc:pen:papers:11-004
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