Dynamic Inconsistency in Risky Choice: Evidence from the Lab and Field

71 Pages Posted: 9 Jun 2020

See all articles by Rawley Heimer

Rawley Heimer

Boston College - Department of Finance

Zwetelina Iliewa

University of Bonn - Department of Economics

Alex Imas

University of Chicago - Booth School of Business

Martin Weber

University of Mannheim - Department of Banking and Finance

Date Written: May 13, 2020

Abstract

Many economically important settings, from financial markets to consumer choice, involve dynamic decisions under risk. People are willing to accept risk as part of a sequence of choices---even when it is fair or has a negative expected value---while at the same time rejecting positive-expected value gambles offered in isolation. We use a unique brokerage dataset containing traders' ex-ante investment plans and their subsequent decisions (N=190,000) and two pre-registered experiments (N=940) to study what motivates decisions to take risk in dynamic environments. In both settings, people accept risk as part of a "loss-exit" strategy---planning to take more risk after gains and stop after losses. Notably, this strategy generates a positively-skewed outcome distribution that is not available when the same gambles are offered in isolation. People's actual behavior exhibits the reverse pattern, deviating from their intended strategy by cutting gains early and chasing losses. More individuals are willing to accept risk when offered a commitment to the initial strategy, which suggests at least partial sophistication about this dynamic inconsistency. We use our data to formally identify a model of decision-making that predicts both the observed deviations in planned versus actual behavior, as well as the discrepancy in risk-taking in static and dynamic environments. We then use this model to quantify the welfare costs of naivete in our setting. Together, our results have implications for evaluating the welfare consequences of behavioral biases in dynamic settings, such as the disposition effect, and highlight potentially unintended effects of regulation mandating non-binding commitment.

Keywords: dynamic risk taking, choice under uncertainty, probability weighting, dynamic inconsistency, behavioral economics, retail trading, limit orders

JEL Classification: D01, D09, D9, G4

Suggested Citation

Heimer, Rawley and Iliewa, Zwetelina and Imas, Alex and Weber, Martin, Dynamic Inconsistency in Risky Choice: Evidence from the Lab and Field (May 13, 2020). Available at SSRN: https://ssrn.com/abstract=3600583 or http://dx.doi.org/10.2139/ssrn.3600583

Rawley Heimer (Contact Author)

Boston College - Department of Finance ( email )

Carroll School of Management
140 Commonwealth Avenue
Chestnut Hill, MA 02467-3808
United States

Zwetelina Iliewa

University of Bonn - Department of Economics ( email )

Adenauerallee 24-42
Bonn, 53113
Germany

Alex Imas

University of Chicago - Booth School of Business ( email )

5807 S. Woodlawn Avenue
Chicago, IL 60637
United States

Martin Weber

University of Mannheim - Department of Banking and Finance ( email )

D-68131 Mannheim
Germany
+49 621 181 1532 (Phone)
+49 621 181 1534 (Fax)

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