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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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  1. Uzi Segal, 1989. "Two-Stage Lotteries Without the Reduction Axiom," UCLA Economics Working Papers 552, UCLA Department of Economics.
  2. Kareen Rozen, 2008. "Foundations of Intrinsic Habit Formation," Cowles Foundation Discussion Papers 1642, Cowles Foundation for Research in Economics, Yale University.
  3. Caplin, Andrew & Leahy, John, 1997. "Psychological Expected Utility Theory and Anticipatory Feelings," Working Papers 97-37, C.V. Starr Center for Applied Economics, New York University.
  4. Gordon, Stephen & St-Amour, Pascal, 1999. "A Preference Regime Model of Bull and Bear Markets," Cahiers de recherche 9906, Université Laval - Département d'économique.
  5. Ulrike Malmendier & Stefan Nagel, 2011. "Depression Babies: Do Macroeconomic Experiences Affect Risk Taking?," The Quarterly Journal of Economics, Oxford University Press, vol. 126(1), pages 373-416.
  6. Gul, Faruk, 1991. "A Theory of Disappointment Aversion," Econometrica, Econometric Society, vol. 59(3), pages 667-86, May.
  7. Thierry Post & Martijn J. van den Assem & Guido Baltussen & Richard H. Thaler, 2008. "Deal or No Deal? Decision Making under Risk in a Large-Payoff Game Show," American Economic Review, American Economic Association, vol. 98(1), pages 38-71, March.
  8. Machina, Mark J, 1989. "Dynamic Consistency and Non-expected Utility Models of Choice under Uncertainty," Journal of Economic Literature, American Economic Association, vol. 27(4), pages 1622-68, December.
  9. Andrew Ang & Geert Bekaert & Jun Liu, 2000. "Why Stocks May Disappoint," NBER Working Papers 7783, National Bureau of Economic Research, Inc.
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