Estimating Risk Preferences in the Presence of Bifurcated Wealth Dynamics: Do We Misattribute Dynamic Risk Responses to Static Risk Aversion?

Abstract

Estimating risk preferences is tricky because controlling for confounding factors is difficult. Omitting or imperfectly controlling for these factors can attribute too much observable behavior to risk aversion and bias estimated preferences. Agents often modify risky decisions in response to dynamic wealth or asset thresholds, where they exist. Ignoring this dynamic risk response introduces an attribution bias in static estimates of risk aversion. We demonstrate this pitfall using a simple model and a Monte Carlo simulation to explore the implications of this problem for empirical estimation. Joint estimation of risk preferences and wealth dynamics may remedy the problem, but can be empirically challenging.

Keywords: Risk, uncertainty, wealth dynamics, risk aversion, risk preference estimation, poverty

JEL Classification: D81, O12, D90