Estimating risk preferences in the presence of bifurcated wealth dynamics: can we identify static risk aversion amidst dynamic risk responses?

Estimating risk preferences is tricky because controlling for confounding factors is difficult. Omitting or imperfectly controlling for these factors can attribute too much observable behaviour to risk aversion and bias estimated preferences. Agents often modify risky decisions in response to dynami...

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Bibliographic Details
Published in:European review of agricultural economics 2013-03, Vol.40 (2), p.361-377
Main Authors: Lybbert, Travis J, Just, David R, Barrett, Christopher B
Format: Article
Language:English
Subjects:
Economic dynamics
Empirical tests
Monte Carlo simulation
Reviews
Risk aversion
Risk theory
Wealth
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Summary:Estimating risk preferences is tricky because controlling for confounding factors is difficult. Omitting or imperfectly controlling for these factors can attribute too much observable behaviour to risk aversion and bias estimated preferences. Agents often modify risky decisions in response to dynamic wealth or asset thresholds, where such thresholds 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. While an approach that jointly estimates risk preferences and wealth dynamics may remedy the problem by extracting dynamic risk responses from observed behaviour, it is likely to be challenging to implement in broader empirical settings for reasons we discuss.
ISSN:0165-1587
1464-3618
DOI:10.1093/erae/jbs027