Dynamics in risk taking with a low-probability hazard

Abstract

The experiment reported in this paper identifies the effects of experience on revealed attitudes toward risk. Subjects in the experiment encountered an uncertain risk of experiencing a negative income shock over multiple periods and were able to purchase insurance at the start of each period. Subjects engaged in greater risk taking, insuring less frequently, when faced with the same risk over multiple periods. Subjects weighted experienced outcomes proportionately, in a manner consistent with rational Bayesian inference and contrary to the theory that individuals exhibit recency bias. On the other hand, subjects assigned a greater weight to outcomes that directly impacted their earnings compared to observed outcomes that had no effect on income. Unexplained autocorrelation across subjects’ choices suggests that inertia also plays an important role in repeated risk settings. I explore the relevance of these findings to public policy aimed at influencing market outcomes in the presence of infrequent environmental hazards.