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MIT Sloan professor develops evolutionary model of risk aversion

CAMBRIDGE, Mass., December 1, 2014—Risk aversion is one of the most widely observed behaviors in the animal kingdom. However, few studies have addressed the question of where risk preferences come from and why they differ from one individual to the next. Studying this issue against the backdrop of the apparent lack of risk aversion that led to the recent financial crisis, MIT Sloan Prof. Andrew Lo has developed an evolutionary model of behavior.

Lo and his co-researchers found that risk aversion emerges as the dominant behavior when reproductive risks are shared across the population. In these environments, seemingly irrational actions can persist because they help perpetuate the species even though they may not benefit any given individual. The key is the commonality of reproductive risk. On the other hand, if the risk is unique to each individual, then risk neutrality emerges as the dominant behavior. Their findings were published in the Proceedings of the National Academy of Sciences today.

“Our results stem from the fact that ‘nature abhors an undiversified bet,’ so when reproductive risk is the same for everyone in the population, the kind of behavior that confers the greatest survival benefits is not the selfish utility-maximizing behavior economists typically assume,” says Lo. “So-called ‘irrational’ behavior may indeed be less than optimal from an individual’s perspective, but it can proliferate nonetheless because it serves as a hedge against extinction.”

Lead author Ruixun Zhang, an MIT Ph.D. student and researcher at the MIT Laboratory for Financial Engineering, which Lo directs, observes, “This hedge is valuable only when the entire population faces the same risk of reproductive failure; if this risk is statistically independent across individuals, then nature has already taken care of the hedging for us.”

In a previous study, Lo and coauthor Thomas J. Brennan of Northwestern Law School showed that well-known behaviors such as probability matching, risk aversion, loss aversion, and randomization can emerge purely through the forces of natural selection. Their work with Zhang extends this framework and focuses on the origin of utility and risk aversion. The new study shows how different environments lead to different stable utility functions over time, and presents an alternate and more fundamental explanation of risk aversion.

These findings have several broader implications for financial economics and public policy. “The role of systematic risk in shaping individual and aggregate behavior provides a more direct biological channel through which the relationship between systematic financial risk and expected asset returns can arise. However, unlike the fixed utility functions assumed in standard economic models, our framework implies that preferences vary over time and across environmental conditions, hence large systematic financial shocks can lead to more risk aversion over time, and vice versa,” says Lo.

From a policy perspective, this research underscores the importance of addressing systematic risk through insurance markets, capital markets, and government policy to allow individuals to transfer or mitigate such risks. If not properly managed, systematic risk can lead to increases in risk aversion, implying higher risk premiums, borrowing costs, and lower economic growth. However, the authors also point out the potential dangers of sustained government intervention, which can become a source of systematic risk as well.

To read the full paper, “The origin of risk aversion,” please visit:
http://www.pnas.org/content/early/2014/11/26/1406755111.full.pdf+html?sid=4db30048-4c51-4c24-b1b8-bd964cd447e8

For more information about Prof. Lo, please visit:
http://mitsloan.mit.edu/faculty/detail.php?in_spseqno=41207