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Is Your Approach to Risk Consistent?

Does the way you handle risk vary depending on the type of financial decision you are making?

The answer is likely yes, according to a recent study by MIT (following is an excerpt from the MIT News Office):

“Take a moment to consider some of the financial choices you’ve made in recent years. Do you have a consistent approach to your money, either by playing it safe or having a willingness to take risks? Or do you not have a set philosophy, and instead make your financial decisions independently of each other?

In economics, classical theory holds that we have consistent risk preferences, regardless of the precise decision, from investments to insurance programs and retirement plans. But studies in behavioral economics indicate that people’s choices can vary greatly depending on the subject matter and circumstances of each decision.

Now a new paper (PDF) co-authored by an MIT economist brings a large dose of empirical data to the problem, by looking at the way tens of thousands of Americans have handled risk in selecting health insurance and retirement plans. The study, just published in the American Economic Review, finds that at most 30 percent of us make consistent decisions about financial risk across a variety of areas.”

Many choices, different degrees of risk

The research used data on the choices made in 2004 by 13,000 employees about their health insurance and retirement plans at Alcoa, Inc., the international aluminum manufacturer whose headquarters are in Pittsburgh.

Those Alcoa employees were faced with choosing plans for five types of health insurance…The workers also had 13 different 401(k) plans available to them, bearing different degrees of risk.

The researchers ranked the employees by risk tolerance…and found that there was significant variation in the financial exposure people were willing to sustain…

The results do come with a twist: The researchers found that the employees’ decisions about the risk levels of their 401(k) plans had less predictive power for their insurance choices than did any of the five insurance choices. Finkelstein says she thinks it is “a reasonable interpretation” to suggest that this discrepancy represents “a large drop in the commonality” of people’s risk tolerance across a diversity of financial domains…”

In other words, most people (around 70%) tend to consider risk very differently depending on what kind of financial decision they are making.


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