CeDEx workshop - Alex Imas (Carnegie Mellon University)

The Realization Effect: Risk Taking after Realized versus Paper Losses

Understanding how prior outcomes affect risk attitudes is critical for the study of choice under uncertainty. A large literature documents the influence of prior losses on subsequent risk attitudes. The results appear contradictory: some studies find that people become more risk seeking after a loss, whereas others show the opposite – that they become more risk averse. In this paper, we demonstrate that these seemingly inconsistent findings can be explained by individuals’ differential responses to realized versus paper losses. Following a realized loss, individuals avoid risk; if the loss has not been realized – a paper loss –individuals take on even greater risk and chase their losses. We also show that giving individuals flexibility in choosing when to realize losses can lead to lower earnings in environments where loss-chasing decreases expected returns. Drawing a distinction between paper and realized losses reconciles prior findings, and is consistent with a framework of prospect theory and mental accounting.