Risk and time preference in financial economics

April 22, 2015 | Hamilton, ON
Contributed by Richard Deaves, Professor, Finance and Business Economics

Richard Deaves discusses his research on how cognitive ability and emotional balance influence financial decision-making.

300px-Risk_dice2A recurring column in the Journal of Economic Perspectives states: “Economics can be distinguished from other social sciences by the belief that most (all?) behaviour can be explained by assuming that agents have stable, well-defined preferences and make rational choices consistent with those preferences in markets that (eventually) clear.”

The two preferences central to financial economics are risk preference and time preference. The first addresses how comfortable someone is taking on greater risk in exchange for (on average) higher reward. The second asks how patient or impatient someone wishes (and is able to be) when it comes to the choice of consuming dollars now vs. saving them for a better standard of living of later.

Given the centrality of these choices it should not be surprising to hear that they have been extensively addressed by researchers. Take risk preference, for example. Older people closer to retirement should and do take on less risk because they have less time to recover from adverse market outcomes. On the other hand, high-income, high-net worth individuals can and do take on more risk, because more of their wealth tends to be held in usually safer human capital. Along the same lines, markers of security such as job seniority and being married lead to lower risk aversion. Holding such factors constant, males are more amenable to risk. There are also a host of rather more subtle determinants, such as genetics, culture, recent experience, and expertise.

Researchers are just starting to pay attention to various psychometric measures. In work that I am now conducting with Quang Nguyen, the extent to which IQ and EQ impact both time and risk preferences is explored.

In short, we find that those with higher cognitive ability and greater emotional stability tend to be better savers and also have a greater stomach for risk-taking, both of which lead to higher levels of wealth accumulation over time and more comfortable retirements.

Richard Deaves research focus is the field of behavioural finance. He has also published on such issues as the performance of investment funds; asset market experiments; market efficiency; modelling interest rates; and pricing, efficiency and hedging in futures markets.

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