The role of cognitive reflection in decision making: Evidence from Pakistani managers

Judgment and Decision Making, Vol. 14, No. 5, September 2019, pp. 591–604 The role of cognitive reflection in decision making: Evidence from Pakistani managers Muhammad Sajid∗ Matthew C. Li† Abstract Assessing how managers discount and evaluate risks is crucial in designing effective managerial policies. In this work, we examine whether risk preferences (RP; both in the domains of gain and loss) and time preferences (TP) are related to managers’ cognitive reflection (CR). To achieve this, the current study focuses on the responses of 601 corporate decision-makers, such as CEO and CFO, of 200 non-financial firms listed at the Pakistan Stock Exchange. Using the three-item of Cognitive Reflection Test (CRT; Frederick, 2005) as a measure of CR, we observe that males perform better on this test than females. Correlation analysis reveals that individuals’ RP in the gain domain are positively associated with their TP, implying that risk-taking individuals are more patient. Our evidence further shows that higher CR is associated with a higher likelihood of increased patience and a lower likelihood of willingness to take risks in the domain of loss. Greater CR is also linked to a higher likelihood of risk-taking in the domain of gain. These findings have important implications regarding the ability of managers to make financial decisions that involve uncertainty and delayed rewards but maximize firm value. Keywords: risk and time preferences, cognitive reflection, judgment, decision making, managers, behavioral economics. 1 Introduction Managers make many decisions in their everyday life involving time discounting and a large degree of uncertainty. Empirical evidence from experimental economics, neuroeconomics and cognitive psychology suggests that risk preferences (RP), preferences for risky versus safe outcomes, and time preferences (TP), preferences for immediate versus deferred outcomes, are related to decision making in many critical real-life domains, such as economics, finance, health and wealth (Anderson and Mellor (2008); Allen, Weeks and Moffitt (2005); Barsky et al. (1997); Boyle et al. (2012); Cohn et al. (1975); Guiso and Paiella (2008); James et al. (2015); Jarmolowicz et al. (2014); Harrison, Lau and Rutström (2007)). For example, people who are risk-averse prefer to invest in safe, low-yield options, such as Treasury bonds, rather than risky, high-yield ones, such as stocks (Cohn et al., 1975). Greater risk aversion is also associated with poor financial and healthcare decision making (Boyle, We thank the 601 anonymous respondents to our survey, whose participation is truly invaluable. For their helpful comments, we also wish to thank the editor, Professor Jonathan Baron, two anonymous referees, Rizwan Mushtaq and participants at the British Accounting and Finance Association 2019 Annual Conference. Financial support from the Punjab Higher Education Commission, the Government College University Faisalabad, The Charles Wallace Pakistan Trust, and Royal Holloway, University of London, UK is also gratefully acknowledged. Copyright: © 2019. The authors license this article under the terms of the Creative Commons Attribution 3.0 License. ∗ Royal Holloway, University of London and Government College University Faisalabad, Pakistan. Email: † Royal Holloway, University of London. Yu, Buchman, et al., 2012), and dangerous health behavior, such as cigarette smoking, heavy drinking and being overweight (Anderson & Mellor, 2008). Likewise, impatience is significantly associated with lower level of income and education (Reimers et al., 2009), poorer school performance (James et al., 2015), being overweight or obese (Chabris et al., 2008; Jarmolowicz et al., 2014; Reimers et al., 2009), smoking (Chabris et al., 2008; Reimers et al., 2009), alcohol consumption (MacKillop et al., 2010; Petry, 2001; Vuchinich & Simpson, 1998), craving (MacKillop et al., 2010), drug addiction (Bickel & Marsch, 2001; Kirby, Petry & Bickel, 1999; Kirby & Petry, 2004), engaging in unsafe sex (Reimers et al., 2009), less exercise (Chabris et al., 2008), higher amounts of credit card debt (Meier & Sprenger, 2010) and under-utilization of health insurance (Hsu, Lin & McNamara, 2008). Thus, understanding how managers discount and evaluate risks is essential for making optimal financial decisions such as investment and risk-taking. Several experimental studies have investigated the role of inter-individual differences, with specific reference to cognitive abilities, in individual risk and time preferences for decision-making. Perhaps importantly, these studies suggest that high-ability individuals tend to reveal preferences that differ from their counterparts. More precisely, the literature demonstrates that higher cognitive ability (CA) is significantly associated with more pronounced patience (Białek & Sawicki, 2018; Booth & Katic, 2013; Frederick, 2005; James et al., 2015; Melikian, 1959; Nofsinger & Varma, 2007; Shamosh & Gray, 2008), more risk-seeking in the domain of gain (Byrnes, Miller & Schafer, 1999; Croson & Gneezy, 2009; Donkers, Melenberg & Van Soest, 2001; 591 Judgment and Decision Making, Vol. 14, No. 5, September 2019 Eckel & Grossman, 2008; Ioannou & Sadeh, 2016; Weber, Blais & Betz, 2002) and greater risk aversion in the domain of loss (Burks et al., 2009; Frederick, 2005; Kirchler et al., 2017; Nofsinger & Varma, 2007; Noori, 2016). However, not all researchers have reached the same conclusion; for example, Andersson, Holm, Tyran and Wengström (2016) suggest both a negative and a positive correlation between risk aversion and CA, while Brañas-Garza, Guillen and del Paso (2008) and Booth and Katic (2013) find no relationship between CA and risk attitudes. Similarly, Kirby, Winston and Santiesteban (2005) document a negative correlation between students’ grades and delay-discount rates, whereas Monterosso et al. (2001) and Noori (2016) do not find any relationship between patient behavior and CA. Results from recent literature of student subjects and general population suggest that CA seems to be the robust predictor of risk attitudes and intertemporal choices (Basile & Toplak, 2015; Białek & Sawicki (2018); Boyle et al., 2011; Cueva et al., 2016; Park, 2016). However, until now, to the authors’ best knowledge, no research has been conducted to test the effects of cognitive reflection (CR) on risk and time preferences among managers. With this backdrop, the present study utilizes data from a sample of 601 managers of 200 non-financial firms listed at the Pakistan Stock Exchange to examine: 1) the associations of risk attitudes with intertemporal choices; 2) gender differences in the Cognitive Reflection Test (CRT); and 3) the correlations between RP (both in the domains of gain and loss), TP and CR. We use Frederick’s CRT to measure CR. RP are assessed using standard behavioral finance questions in which subjects were asked to choose between a certain payoff or a gamble in which they could gain more or g (...truncated)