The Realization Effect: Risk-Taking after Realized versus Paper Losses
Carnegie Mellon University - Department of Social and Decision Sciences
March 23, 2014
Understanding how prior outcomes affect risk attitudes is critical for the study of choice under uncertainty. A large literature documents the influence of prior losses on subsequent risk attitudes. The findings appear contradictory: some studies find that people become more risk seeking after a loss, whereas others assert the opposite -- that they become more risk averse. In this paper, we show that these seemingly inconsistent findings can be explained by individuals' differential responses to realized versus paper losses. Following a realized loss, individuals avoid risk; if the loss has not been realized -- a paper loss -- individuals are more likely to chase their losses and take on even greater risk. We provide support for our framework using existing data and across two experiments. We also show that giving individuals flexibility in choosing when to realize losses can lead to lower earnings in environments where loss-chasing decreases expected returns. Drawing a distinction between paper and realized losses reconciles prior findings, and has important implications for contract design and optimal monitoring.
Keywords: dynamic risk attitudes, prior losses, choice bracketing
JEL Classification: D03, D81, G02
Date posted: March 4, 2014 ; Last revised: August 22, 2014
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