WP 2011-17 Asset Integration and Attitudes to Risk: Theory and Evidence

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Forthcoming – Review of Economics & Statistics.

ABSTRACT. Measures of risk attitudes derived from experiments are often questioned because they are based on small stakes bets and do not account for the extent to which the decision-maker integrates the prizes of the experimental tasks with personal wealth. We initially provide evidence that risk attitudes over small stakes bets in Denmark are consistent with payoff calibration paradoxes. We then exploit the existence of detailed information on individual wealth of experimental subjects in Denmark, and directly estimate risk attitudes and the degree of asset integration consistent with observed behavior. We hypothesize that the behavior of the Danes in our experiment is consistent with partial asset integration. That is, we hypothesize that they behave as if some fraction of personal wealth is combined with experimental prizes in a utility function, and that wealth and experimental income are not perfectly substitutable. Our specification allows us to test the special cases in which there is no asset integration at all or there is full asset integration. In general, our subjects do not perfectly asset integrate. In the aggregate, the evidence favors zero asset integration. When we examine the evidence at the individual level, the overall conclusion remains the same for well over 80% of our sample, and none fully asset integrate. The implied risk attitudes from estimating these specifications indicate risk premia and certainty equivalents that are a priori plausible under expected utility theory or rank dependent utility models. This theory and evidence is therefore one constructive solution to payoff calibration paradoxes. We identify some special cases in which the partial asset integration approach fails to mitigate these calibration problems. In addition, the rigorous, structural modeling of partial asset integration points to a rich array of connections to the broader literature on risk preferences.