03:12am Thursday 24 August 2017

Why someone else should make your financial decisions

Why someone else should make your financial decisions

Or is it wise to delegate decisions to someone else? Researchers at Lund University in Sweden and other institutions have demonstrated that letting someone else be in charge of your personal finances can help you avoid costly mistakes. In a large-scale experiment they show that people who make decisions on behalf of others are less prone to loss aversion, one of the most well established departures from rational decision-making.

Generally, people suffer more from losing a dollar than they appreciate gaining a dollar. This creates a counterproductive bias known as loss aversion.

“Loss aversion could for example restrain people from buying risky assets and participate in the stock market although this is likely to be profitable for them”, says Erik Wengström, Associate Professor in Economics at Lund University.

Loss aversion has been used to explain behavior in a wide range of situations including tax evasion and the housing market. Even professional golf players have been found to display loss averse behavior. In order to investigate whether it is possible to avoid the negative effects of loss aversion, the team of researchers conducted a large-scale economic experiment administered to a random sample of the Danish population.

In the experiment, participants made a series of choices between a risky and a safe gamble. After the experiment, participants were paid according to one of the gambles.

In a baseline group, participants chose gambles for themselves. In a second group, participants made choices on behalf of someone else. That is, after the experiment, another subject was paid according to the decision maker’s choices. In a third group, both the decision maker and another participant were paid based on the decision maker’s choices.

When no losses were possible, participants choose about the same amount of risk across all groups. In line with loss aversion, participants became more risk avoiding when they could lose money. However, the participants in the groups that made decisions on behalf of others were less affected by the introduction of losses. This indicates that making decision on behalf of others reduced loss aversion.

“Our study shows that one way to reduce the negative effects of loss aversion may be to let someone else make the decision for you. Since loss aversion makes people reject profitable investments, letting someone else be in charge can increase the expected returns”, says Wengström.

One potential explanation for these findings is that loss aversion is driven by our quick and intuitive decision system. Loss aversion may represent an instinctive reaction driven by a hard-wired fearful overreaction. Involving someone else in the decision process may activate the more reflective decision system. This helps spotting the costly tendency of being overly sensitive to losses. While delegating choices to others may come at a risk of losing control, letting someone else make decisions on your behalf may serve as a mechanism for moderating loss aversion.

The study also showed that the group that made decisions for both others and themselves showed the same results as those only making decisions for others.

“Taken together, the results suggest that people may not always be better off when given the opportunity to choose for themselves”, Wengström concludes.

Ola Andersson, Håkan J. Holm, Jean-Robert Tyran, Erik Wengström (2015) “Deciding for Others Reduces Loss Aversion”,forthcoming in Management Science, available online

Erik Wengström, Associate Professor, Department of Economics, School of Economics and Management at Lund University
+46 708 396 111

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