Stakes and mistakes

We provide causal evidence on one of the most prominent critiques of behavioral finance – that most of the evidence in psychology, which underpins the field, comes from experiments with little at stake for participants. How far do behavioral biases – leading to investment mistakes – get attenuated when stakes are raised? We study this issue by exploiting exogenous variation in stakes resulting from unexpected inheritances due to sudden parental death. We find that increasing stakes reduces investment mistakes, but this effect is economically small. Mistakes do not disappear when stakes are raised, even when this increase is substantial. * This draft has benefited from comments from seminar participants at Copenhagen Business School and the Hong Kong University Science and Technology. This work is supported by the Hong Kong Research Grant Council through RGC Project 16502019. Andersen and Nielsen thank the Danish Finance Institute for financial support. Send correspondence to Kasper Meisner Nielsen, Department of Finance, Copenhagen Business School, Copenhagen, Denmark; telephone: +45 3815 3593. E-mail: kmn.fi@cbs.dk. 1 Behavioral finance as a field has grown dramatically in popularity over the last three decades. The field has documented systematic patterns of investor behavior and prices that are consistent with experimental evidence in psychology, sometimes even when this evidence contradicts basic tenets of rationality (Barberis and Thaler, 2003). However, both practitioners and critics of behavioral finance have also pointed out a few important reasons for skepticism. One of the most prominent ones is the fact that most of the evidence in psychology – which underpins the field – comes from experiments with little at stake for participants. The argument goes that once we examine behavior in situations with high stakes – like real-world financial decisions – many documented biases might weaken substantially. Levitt and List (2008) express this concern eloquently: “Perhaps the greatest challenge facing behavioral economics is demonstrating its applicability in the real world. In nearly every instance, the strongest empirical evidence in favor of behavioral anomalies emerges from the lab. Yet, there are many reasons to suspect that these laboratory findings might fail to generalize to real markets. ” Whether laboratory findings might generalize to real world financial markets where stakes are undoubtedly more substantial is particularly difficult to test. One could point out specific situations, such as biases in retirement account decisions, where stakes do not seem to undo biases (e.g., Benartzi and Thaler, 2001); but saying something more general about stakes and mistakes is difficult. The literature has made progress on this issue in two different directions. First, many papers have considered the effect of increasing stakes in experiments. The evidence form these studies is mixed. For example, Camerer and Hogarth (1999) review seventy-four experiments that vary incentives, and find that in typical tasks of interest to financial economists – like trading in financial markets or choosing among risky assets – increased incentives do not substantially change average behavior. On the other hand, Andersen et al (2011) examine ultimatum games, and show that increasing stakes can indeed change rejection rates in the experiment. Besides, one key issue with such an approach varying experimental rewards is that budgetary limits make it difficult to raise stakes to real-world levels; even in high-incentive conditions, rewards are an order of magnitude smaller than in financial markets. Second, papers like Vissing-Jorgensen (2002, 2003) and Massa and Simonov (2006) have examined the relation between wealth and investment biases. They find that wealthier participants exhibit less biases. While this evidence is consistent with the view that higher stakes reduce biases, it is not causal. The main endogeneity concern arises from the fact that the level of wealth is likely to be correlated