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Portfolio Choice and Risk Attitudes: an Experiment PORTFOLIO CHOICE AND RISK ATTITUDES: AN EXPERIMENT GARY CHARNESS and URI GNEEZY* Using financial incentives, we study how portfolio choice (how much to invest in a risky asset) depends on three well-known behavioral phenomena: ambiguity aversion, the illusion of control, and myopic loss aversion. We find evidence that these phenomena are present and test how the level of investment is affected by these motivations; at the same time, we investigate whether participants are willing to explicitly pay a small sum of money to indulge preferences for less ambiguity, more control, or more frequent feedback/opportunities to choose the investment level. First, the observed preference for ‘‘control’’ did not affect investment behavior and in fact disappeared when participants were asked to actually pay to gain more control. Second, while people were indeed willing to pay for less ambiguity, the level of ambiguity did not influence investment levels. Finally, participants were willing to pay to have more frequent feedback opportunities to change their portfolio, even though prior research has shown that people invest less in risky assets (and earn less) in this case.(JEL B49, C91, D81, G11, G19) I. INTRODUCTION decisions, in recent years a body of empirical evidence suggests that there are systematic Suppose an investor is faced with a decision departures from this behavior. Behavioral concerning how to allocate financial resources finance is concerned with psychological influen- between a risky lottery (asset) with a higher ces in financial decision making and markets. expected return and an asset with a fixed and Investors make decisions while trying to stay guaranteed lower return. Is the choice of port- afloat in a sea of uncertainty; when predictabil- folio independent of preferences outside the standard neoclassical model? In experiments ity is low, people may be prone to unjustified beliefs that may survive and even flourish in with financial incentives, we study how port- such an environment.1 People may resort to folio choice depends on three well-documented ‘‘rules of thumb,’’ on a conscious or subcon- behavioral phenomena: ambiguity aversion, scious level. To the extent that psychological the illusion of control, and myopic loss aver- influences are present, it is economically impor- sion. We also investigate whether participants tant to consider which of these actually affect are willing to explicitly pay a small sum of risk attitudes and portfolio choice. A key issue money to indulge such preferences (pay for is whether any such influences disappear when more perceived control, less ambiguity, or more monetary incentives are present. frequent opportunities to change the portfolio based on feedback about its performance). We pursue a systematic experimental compar- ison of three of the most prominent behavioral While standard finance theory presumes that investors successfully identify and process information relevant to reaching optimal 1. It might seem natural to assume that investors who behave ‘‘irrationally’’ (e.g., do not process information optimally) can be exploited and driven from the market over time; however, several theoretical models (e.g., *We thank Matthew Rabin, Richard Thaler, Martin Benos, 1998; Gervais and Odean, 2001; Hirshleifer and Weber, and seminar participants for their comments Luo, 2001; Kyle and Wang, 1997) demonstrate that, for and suggestions. All errors are our own. example, overconfidence can persist in the long run. Charness: Professor, Department of Economics, Univer- sity of California at Santa Barbara, Santa Barbara, CA 93106-9210. E-mail: [email protected] ABBREVIATION Gneezy: Professor Rady School of Management, Univer- sity of California at San Diego, La Jolla, CA 92093- MLA: Myopic Loss Aversion 0093. E-mail: [email protected] 133 Economic Inquiry doi:10.1111/j.1465-7295.2009.00219.x (ISSN 0095-2583) Online Early publication June 22, 2009 Vol. 48, No. 1, January 2010, 133–146 © 2009 Western Economic Association International 134 ECONOMIC INQUIRY phenomena documented in the literature. The guity, but having less ambiguity does not influ- illusion of control (Langer 1975) is concerned with ence their portfolio choice; finally, in some greater confidence in one’s predictive ability or in cases people are willing to pay money for afavorableoutcomewhenonehasahigherdegree more frequent feedback and opportunities of personal involvement, even when one’s to change their portfolio, but, again, previous involvement is not actually relevant. Ambiguity studies have shown that people invest less aversion (Ellsberg 1961) is the desire to avoid with this additional information and greater unclear circumstances, even when this will not flexibility! increase the expected utility. Myopic loss aversion (Benartzi and Thaler 1995) combines loss aver- sion (Kahneman and Tversky 1979; Tversky II. BACKGROUND and Kahneman 1992) and a tendency to evaluate outcomes frequently. This combination leads In this article, we start with the phenome- investorstobemorewillingtoinvestagreaterpro- non at issue, and ask how it affects financial portion of their portfolio in risky assets if they decisions. We provide simple tests for both evaluate their investments less frequently. the existence of these phenomena in financial We show that these phenomena are present decision making and their persistence in the with monetary incentives and also investigate face of a clear financial disincentive. We whether people are willing to pay money to now discuss these in turn, and review the rel- accommodate such preferences, or whether evant empirical and experimental work. they are closer to the rational model when incentives are present. With the procedure A. Ambiguity Aversion we chose, the willingness to actually pay for such preferences depends on the preference. Knight (1921) distinguishes between risk The great majority of investors pay for less and uncertainty, with risk being quantifiable ambiguity or more frequent feedback/invest- in terms of explicit probabilities. The Savage ment opportunities, but fewer than 10% pay (1954) axioms preclude any role for vagueness to roll a determinative die themselves.2 in a rational theory of choice. The famous We then examine how the preferences Ellsberg (1961) paradox provides persuasive between lotteries in the different treatments examples in which people prefer to bet on affect portfolio choice. We have participants known distributions. In one decision task, allocate their investment capital between an Urn 1 contains 50 red and 50 black balls, asset with a sure return and a risky asset with whereas Urn 2 contains 100 red and black a higher expected rate of return. In fact, there balls in unknown proportions. People prefer is very little variation in investment behavior to make bets with respect to the 50–50 urn. across any of the illusion of control or ambi- Ellsberg argues that it is not only subjective guity aversion treatments. In contrast, the probability that matters, but also the vague- results found in previous experimental studies ness or ambiguity of the event in question of myopic loss aversion suggest that partici- (see Camerer and Weber 1992 for a review pants invest less in their preferred option. of the literature on variations of the Ellsberg The main conclusion we draw from these paradox). This observed behavior is called findings is that the relation between which a paradox because it violates Savage’s axioms. procedure or lottery people prefer, and how Ambiguity aversion has attracted consider- much they are willing to actually invest in this able interest, as it is rare (outside of games of lottery is not trivial at all. People are generally chance) to know precise probabilities when unwilling to pay even small amounts of money buying a security, filing a lawsuit, or choosing to indulge the illusion of control, and it does a graduate program. Yet, evidence is some- not influence their portfolio choice; people are what mixed concerning the effect of ambiguity generally willing to pay money for less ambi- aversion on financial decision making. Heath and Tversky (1991) test whether ambiguity aversion is a factor only in the realm of chance 2. We do not make a general claim regarding these events, or whether it also extends to uncer- preferences and how they survive financial incentives. tainty about knowledge of world events. They We only choose arbitrary parameters for these to investi- gate the relationship between how much a person likes find that people prefer to bet on chance when a lottery and how much he or she is willing to invest in it. they do not feel confident, but prefer to rely on CHARNESS & GNEEZY: PORTFOLIO CHOICE AND RISK ATTITUDES 135 their vague beliefs in situations where they feel active involvement all lead to inflated confi- particularly knowledgeable or confident. Thus, dence beliefs. For example, Langer found that perceived self-confidence or competence can people who were permitted to select their own trump one’s aversion to ambiguity. numbers in a lottery game (hypothetically) Sarin and Weber (1993) test whether ambi- demanded a higher price for their ticket than guity aversion can survive market incentives did people who were assigned random num- and feedback, using market experiments with bers. Since this initial study, many other sealed-bid and double-oral auctions and researchers have found that people often per- sophisticated subjects (graduate business stu- ceive more control than they actually have, dents and bank executives). Each participant make causal
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