When imagining future wealth influences risky decision making

Judgment and Decision Making, Vol. 8, No. 3, May 2013, pp. 268–277 When imagining future wealth influences risky decision making Adam Eric Greenberg∗ Abstract The body of literature on the relationship between risk aversion and wealth is extensive. However, little attention has been given to examining how future realizations of wealth might affect (current) risk decisions. Using paired lottery choice experiments and exposing subjects experimentally to imagined future wealth frames, I find that individuals are more risk-seeking if they are asked to imagine that they will be wealthy in the future. Yet I find that individuals are not significantly more risk-averse if they are asked to imagine that they will be poor in the future. I discuss theoretical and policy implications of these findings, including why savings rates are so low in the United States. Keywords: risky decision making, framing, wealth, savings, expected utility. 1 Introduction Understanding the effect of future wealth on risk aversion is essential for uncovering the puzzle of why household savings is low in the United States. In particular, there are compelling reasons to believe that many choices are motivated, in part, by how we imagine our future states of wealth. Individuals constantly struggle between “risky” and “safe” options—whether to become a rock star or a music teacher, be an entrepreneur or work for a company, etc.—that are ultimately chosen based on upside or downside potential. But I know of no research that examines the relationship between imagined future wealth and risky decision making. The relationship between wealth and risk aversion is well-documented in the economics literature (Kihlstrom et al., 1981; Brunnermeier & Nagel, 2008; Sousa, 2010; Paravisini et al., 2011). Yet pioneers of the theory of the utility of wealth did not reach a consensus about the direction of this relationship.1 Expected-utility theory (EUT) remains the dominant framework for examing the relationship between wealth and risk. EUT predicts that individuals maximize their expected utility based on probabilities and outcome utilities of possible levels of A version of this paper constituted my senior thesis at Vassar College. I am indebted to Sean Masaki Flynn for his guidance and support. I am grateful to two anonymous referees as well as Jonathan Baron and Jean-Robert Tyran for insightful comments. I also thank Ben Bradshaw and Vincent Leah-Martin for excellent research assistance. This research was supported by the Academic Support and Enrichment Fund at Vassar College. Copyright: © 2013. The authors license this article under the terms of the Creative Commons Attribution 3.0 License. ∗ University of California, San Diego, Department of Economics, 9500 Gilman Drive, La Jolla, CA 92093; 1 Friedman and Savage (1948) argued that the curvature of the utility function predicts a lower propensity for risk in wealthy individuals and a greater taste for risky decisions in less wealthy individuals, while Markowitz (1952) argued the opposite relationship. wealth. But extensive research (e.g., Kahneman & Tversky, 1979; Rabin, 2000; Rabin & Thaler, 2001) has challenged the sufficiency of EUT as a descriptive account. Inquiries about how future reference point realizations could affect (current) economic decisions have not been investigated. In particular, how does imagining a future wealth scenario change our decisions today? This type of question has several economic applications; its implications for savings behavior, in particular, are discussed here. This paper studies behavior in paired lottery choice experiments to experimentally test whether hypothetical future realizations of wealth alter individuals’ current risk decisions. In particular, I am interested in whether changes in hypothetical wealth frames affect risk aversion. My hypotheses are derived from EUT with decreasing relative risk aversion. I hypothesize that (H1) those who imagine they will be wealthy will take more risks because they are prompted to think that they can afford to take more gambles and (H2) those who imagine they will be poor will take fewer gambles since they believe they cannot afford to take risks. EUT with decreasing relative risk aversion would predict that individuals respond to an exogenous increase in wealth by taking more risks and respond to a decrease by taking fewer. I find that those who are asked to imagine themselves as wealthy in the future make significantly riskier decisions today. Yet those who are asked to imagine themselves as poor in the future are not significantly more risk-averse in their current decisions. 2 Previous work The existing research on how framing affects choice is extensive (beginning with Tversky & Kahneman, 1981, 268 Judgment and Decision Making, Vol. 8, No. 3, May 2013 and Hershey et al., 1982). It is important to note, as well, that framing has real effects on economic behavior. Consistent with prospect theory, researchers have found that gain and loss frames alter choice decisions, even if the underlying decisions are the same. Epley and Gneezy (2007) argued that the framing of financial windfalls can change how people spend their income. In particular, income that is perceived as a positive departure from individuals’ reference points (e.g., bonus) is spent more easily than that which is perceived as undoing a negative departure (e.g., refund). In addition, the outcomes of prior events have been shown to affect identical decisions. Coval and Shumway (2005) found that investor losses in the morning often lead to risky behavior in afternoon trading. In this case, while investment decisions should be based on future returns, they are also based on whether the investor is a winner or a loser at the time of the decision. While economic theory has predictions for how expectations about the future affect current decisions, empirical and experimental tests are sparse. One such study examining the link between expected future income and risk decisions using survey data found that households that are more likely to face uncertainty about future income or about to become liquidity constrained are more riskaverse (Guiso & Paiella, 2008). In another study, Carroll (1994) reports that consumption decisions are unaffected by expected changes in income, which is consistent with consumption smoothing. Binswanger (1980) found that wealth reduces risk aversion, but only slightly (and not significantly). But this study, in particular, did not examine future wealth, and its sample comprised unskilled laborers in rural India. The present study is apparently the first to experimentally test the relationship between imagined future wealth and (current) risk decisions. I examine the effect of future wealth frames (wealthy and poor) on hypothetical risky decisions involving money. These types of frames are common in the psychology literature as experimental tools (Garry et al., 1996; Anderson, 1983; Carroll, (...truncated)