Title: The ecology of risk taking
Description: We analyze the risk level chosen by agents that have private information regarding their quality. We show that even risk-neutral agents will choose risk strategically to enhance their reputation in the market, in a manner to determined by the risk choices of other agents. Our model employs the following sequence: (1) an agent learns his type, which determines the opportunity locus relating risk and expected payoff; (2) the agent selects a level of risk; (3) a period payoff is reaped; (4) the market draws inferences from the period payoff; and (5) the agent receives a reward that is positively related both to his period payoff and to his reputation. We analyze separately the cases of observable choice of risk. When the choice of risk level cannot be observed, good agents will choose low levels of risk, and bad agents high levels, provided the market has no strong prior about whether agents are good or bad. Good agents are seeking to reduce noise so as to stand out; bad agents are seeking to increase noise in the hope of producing the results of good agents. When the choice of risk level is observable, pooling behavior is to be expected: agents of different qualities choose identical, low levels of risk. Empirical evidence is gathered on 2462 firms over 24 years. In the corporate context, risk choices are likely to have a significant unobservable component. As conjectured, the evidence rejects the model where risk choice is observable and bad firms thus mimic good firms.