Tail Events, Emotions and Risk Taking
93 Pages Posted: 15 Jun 2020
Date Written: May 20, 2020
Recent works have shown how tail events could account for ﬁnancial anomalies such as the equity premiumpuzzle. These models do not explore, however, why investors would discount tail risk so heavily. We take on this challenge by designing a novel tail-event experiment to assess both investors’ behavioral and physiological reactions. We show that investors who observe the tail event without suﬀering losses tend to decrease their pricing of the asset subsequently. By contrast, loss-averse investors who suﬀer tail losses tend to increase their bids. This response is especially pronounced for those who exhibit a strong emotional response to tail losses. This demonstrates the key role played by emotions in inﬂuencing investors’ response to tail events. Finally, investors who exhibit high anticipatory arousal, as measured with electrodermal activity, posted lower bids and were less likely to suﬀer tail losses and go bankrupt. They also achieved higher earnings when tail events occurred frequently. This ﬁnding contrasts with the common view that investors should silence their emotions.
Keywords: tail events, emotions and risk
JEL Classification: C91, G41, D87, D91
Suggested Citation: Suggested Citation