Americans Inconsistent on Financial Risk

A new paper in the American Economic Review (abstract; PDF), summarized here, finds that Americans aren’t very consistent when thinking about financial risk. Liran Einav, Amy Finkelstein, Iuliana Pascu, and Mark R. Cullen analyzed how people choose health insurance and 401(k) plans and found that “at most 30 percent of us make consistent decisions about financial risk across a variety of areas.”  Their data set includes 13,000 Alcoa employees:

Because employees were making decisions in both the health-care and retirement domains, the researchers had the opportunity to see how the same individuals handled different types of choices. Or, as Finkelstein puts it, the economists could ask: “Does someone who’s willing to pay extra money to get comprehensive health insurance, who doesn’t seem willing to bear much financial exposure in a medical domain, also tend to be the one who, relative to their peers, invests more of their 401(k) in [safer] bonds rather than stocks?”

“I think you could look at these results legitimately through two very different lenses,” Finkelstein explains. “You could say, if 30 percent of our sample is making consistent choices across all six domains, that suggests there is a fair amount of generality in people’s risk preferences, and the classical model has some bite. Or you could say, if just 30 percent of people are making choices that are consistent across domains, there are a lot of context-specific risk preferences.”  

(HT: The Big Picture)

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  1. Colin Young says:

    I disagree with the premise that bonds are safer than equities. Over what timeframe? Over 20 years (e.g. 45 year old) do I really want to opt for a likely 7.6% return vs. a likely 10% return? Or a 30 year old who is perhaps expecting to have children and therefore taking on a significant near-term medical risk? Seems that the rational choice would be conservative medically and aggressive financially.

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    • pawnman says:

      Agreed. A medical emergency would likely ruin someone with my income were I not insured. An under-performing 401(k) will not ruin someone in their mid-30s they way a half-million dollars in medical costs will. The question is, do the people who spend the extra money on the medical insurance become more financially conservative as retirement age approaches?

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  2. Seminymous Coward says:

    I have fancy health insurance because my employer pays the overwhelming majority of the premiums. I have a high-risk retirement portfolio because I don’t intend to retire for a long time. I don’t think this makes me inconsistent.

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  3. Joe J says:

    Hmmm, I know I’m more of a deliberate context specific risk person, because of my individual situation. I know my family health history, which is a concern, so my percieved health risks are greater than one of my age would assume. Likewise my estimation of how long into retirement I’d actually need to finance is different from most in my age. I am doing well financially, in adition I used to be poor, so I know I can thrive with much less financially. That knowledge allows me to have high risk tolerance for my age for financial endevors, but low risk tolerance with health.
    A friend is in the opposite situation, his family has above average longevity andhealth. His health concerns are minimal, so allowing him greater health risk taking. Wit 2 grandparents in their 90s he is also aware of how long ane expensive retirement can be.

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    • Enter your name... says:

      That’s exactly my thought. If you’ve got significant medical issues, then getting the highest-paying health insurance that you can is not a reflection of your tolerance for risk. It’s a reflection of knowing more about your personal situation than the study authors do.

      Similarly, there are people who really have low tolerance for risk, but simply can’t afford more comprehensive health insurance at this time. Having a high deductible might be very stressful for them, but saving $100 a month means that they’re not homeless right now. Or it could be that they’re also covered by a second policy (like a family policy through the spouse’s employer), so the perceived risk is actually much lower.

      I think you’d need to ask individual people why they made the choices that they made.

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  4. x says:

    Based on my personal experience, I suspect that this is more of an issue of different information being available about each. It’s not like there’s some consistent risk number that people see when making these choices that could help guide them to make the choices in the same way.

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  5. hanmeng says:

    Doesn’t this have a connection to the phenomenon discussed in “The Effect of Myopia and Loss Aversion on Risk Taking: An Experimental Test” (Richard H. Thaler, et al.)?

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  6. Mitchell Ayer says:

    The idea that bonds are less risky than stocks is nuts. That overlooks the biggest and most predictable risk-inflation. With the Obama administration borrowing 45 cents of every dollar it spends, inflation is a certainty. A bond will be paid back in tiny Obama dollars.

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  7. Sam says:

    “Risk” is an interesting word. Given that long-term, stocks out-perform bonds significantly, for someone of moderate age, bonds are really not the low-risk option – they’re more the guaranteed-bad-performance option.

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