Home > Behavioural Economics > Why are people risk adverse?

Why are people risk adverse?

February 19, 2014 Leave a comment Go to comments

RiskOne of the major concerns with regard to economic growth, especially in the US, the is lack of risk taking i.e. Entrepreneurial decision-making, self-employment etc. Ultimately risk-taking is the fulcrum of the economic cycle of booms and slumps which John Maynard Keynes referred to Animal Spirits. However research in Behavioural Economics has shown that there is a reason for this behaviour. A recent Free Exchange article in The Economist discussed this area.

A simple test that has been carried out is as follows. Would you prefer:

1. A gift of $50, or
2. To play a game with a 50% chance of winning $120

It might seem logical to chose the second option since the average return in $60. However most people chose the more secure option rather than take the risk. But risks do vary according to the individual and the time period.

Individual as risk taker

The following are seen as influences in risk behaviour:
1. Education – more educated likely to take risks
2. Income – the higher the income the more likely to take risks
3. Gender – Men more likely to take risks

Historically

Research shows that those people who experienced high returns on the stockmarket in their early years were likely to tolerate more risk to own shares as a higher proportion of their income. However a bad experience can dampen risk-taking and this would be prevalent today with the impact of the GFC. Also after the Wall Street crash of 1929 the US economy came to standstill as people were very tentative of taking any risks after what they had been through.

It is not just a financial crisis which affects risk-taking. The tsunami that hit South-East Asia in 2004 and Japan in 2011 can put an end to risk-taking as people rebuild their lives. Furthermore military conflicts such as the Korean war can cause their victims more cautious for long periods of time.

Horror Story = Risk Aversion

One group of universtiy students watched a horror story which contained a gruesome torture scene whilst another group didn’t. On completition of the horror scene both were asked some questions about their propensity for risk. Students who had seen the horror story reported increased aversion to risk by roughly the same amount that the GFC had on people. With this in mind the GFC in likely to restrict consumers from taking the sort of risks that help propel the economy for decades to come. It could be that the lack of entrepreneurial spirit will hinder growth and governments rather than worry about debt will have a lack of risk-takers to deal with.

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