Roberto Robatto is an assistant professor of finance at the Wisconsin School of Business. While his main research interests are banking, macroeconomics, and monetary policy, he also is interested in understanding the theoretical basis of attitudes toward risk. Robatto spoke with WSB about his latest research on the topic of risk and human evolution, which was published in the Journal of Economic Theory in a paper co-authored by Balázs Szentes of the London School of Economics.
WSB: Tell us about your research for this paper. In this paper you study how individuals behave when facing risk and why, correct?
Robatto: Yes, our paper takes a biological approach in the sense that, if evolution determines physical characteristics, it can also determine behavioral choices. Even though the challenges that we face today are vastly different from those of our early ancestors, we still posit that these preferences and ways of decision-making are inborn, part of our genetic makeup. So we can think about these choices really more as extensions of optimal evolutionary behaviors—things our species have carried forward with us through time—rather than deliberate rational choices or personal preferences that we make.
This is a departure from most other economic models that incorporate preferences as a given.
WSB: The paper addresses two types of risks that populations face: aggregate and idiosyncratic. Can you elaborate on the significance of those two types of risk?
Robatto: Idiosyncratic risk is risk that affects each individual differently, while aggregate risk affects everyone in an equal manner. The key question of our paper is whether or not people behave differently when faced with one type of risk versus the other.
The answer is, it depends. Past literature showed that people behave differently when facing all types of risks, aggregate or idiosyncratic, across all circumstances. We wrote a more general mathematical model than those used in previous studies that includes a larger set of scenarios. We find that people behave differently only in some scenarios, whereas they behave equally in others.
To delve a bit deeper, our scenarios include “natural disasters,” such as earthquakes and floods, and “environmental shocks.” In the context of biological evolution, examples of environmental shocks are variations in the availability of food and water. The previous literature includes only natural disasters, whereas we include both. Since natural disasters have a large impact in a short period of time, they are fundamentally different from environmental shocks. The behavior of people facing natural disasters differs depending on whether the risk is aggregate or idiosyncratic, whereas the behavior facing environmental shocks is independent of the type of risk.
WSB: What are some of the implications of this study?
Robatto: Understanding how people behave in a risk situation is a basic and very important question in finance and many other areas. Take investment, for example. I teach investment and I tell students that if you want a high return on your investment, you’ve got to be taking more risks. You need to accept the possibility that there will be situations where your return is going to be much lower than you expected. If you want a higher return, you’re going to have to get comfortable with risk. How much more risk am I willing to take for an extra one percent of return?
Let’s say you’re a consultant for an individual or for a nonprofit foundation. You need to understand not only this tradeoff between risk and return, but also how people think and whether they can accept a certain amount of risk or not. So, there are real-world implications in finance, in economics, in the nonprofit sector, and many other fields. Understanding how risk and behavior are intertwined is key.
Read the paper “On the Biological Foundation of Risk Preferences” published by the Journal of Economic Theory.
Roberto Robatto is an assistant professor in the Department of Finance, Investment, and Banking at the Wisconsin School of Business.