Risk Attitude, Investments, and the Taste for Luxuries Versus Necessities

Individuals should differ in their tolerance for risky financial investments. For one thing, people face different income streams. A freelance writer typically faces considerable variability in income, and long-term unpredictability. These should generally be compensated by less risky investment. But a tenured professor faces little variability or unpredictability and can thus afford to take more risks elsewhere, other things being equal. For another thing, people have different tastes for expenditures. Some people value the “finer things” that money can buy, while others are convinced that the best things in life are free. Individual differences in the taste for luxury should thus affect the utility function for money, e.g., income in retirement. Such differences can provide a test of methods for assessing the utility function. Those with no particular interest in luxuries should have a concave utility function: a reasonable amount of money is sufficient and much more will not improve life that much. Those with more interest in luxuries should have utility functions closer to linear. The former should be more risk averse in investing, other things being equal, in line with expected-utility theory. I have argued that we should think of utility as something real in the sense in which time and longitude are real, i.e., a measure based on a conception that we superimpose on the world (Baron, 2008), yet the same thing regardless of how we measure it. Utility is not just the output of a black box, such as the answer that subjects give to questions about hypothetical monetary gambles. Such answers could be wrong, just as sundials are wrong about time and bad chronometers lead to errors in assessing longitude. Yet, investment advisors often use hypothetical gambles to provide advice about saving for retirement. Measures of risk attitude based on gambles are influenced by many other factors aside from the utility of money (Schoemaker, 1993; Baron, 2008). For example, decisions about risks are affected by: general beliefs about risk taking as a character trait, such as a desire to avoid being foolhardy, or timid; personality traits such as impulsiveness, anxiety level, and sensation-seeking; social pressures connected with these beliefs; superstition; anticipation of emotional reactions to losses, such as regret, guilt feelings (if others are affected), and disappointment, which go beyond the financial consequences in terms of lost purchasing power; lack of understanding of comparative risks and benefits, or the risk/benefit trade-off; mis-perceptions of probability, such as neglect or exaggeration of very low probabilities; and isolation of individual decisions, so that they are not seen in the context of a total portfolio of income streams from various sources. Moreover, hypothetical gambles provide results that are internally inconsistent (Baron, 1997). More direct measures of utility, such as those based on comparison of differences, may be more valid, and they are at least as justifiable on theoretical grounds (Krantz et al., 1971; Baron, 2008, Chapter 4). I report a small study suggesting that difference-based measures are more sensitive than gamble-based measures to the taste for luxuries. My approach was to ask people to evaluate a sample of possible expenditures, which I then place, post hoc, along a continuum from necessities to luxuries.