Counter-cyclical risk aversion explains a lot

There usually is the assumption by economists that risk aversion does not change through time. We can have risk aversion change with wealth, but it makes it a lot easier to assume the stability of risk aversion across different environments. Unfortunately, this assumption leads to such anomalies as the equity risk premium puzzle. New models have been developed to explain risk aversion increases during financial busts which can then be used to explain away the equity risk premium puzzle. These consumption-based habit formation models suggest that risk aversion increases as asset prices and wealth fall and we approach our long-term consumption or habit levels. Nice models, but we have limited evidence on counter-cyclical risk aversion behavior.

Recent research shows that risk aversion can be counter-cyclical with the financial cycle. When faced with a boom or bust environment,  many become more risk aversion if they believe that they are in a period of bust. When the roller-coaster of markets take over, fear kicks in. 

In the latest issue of the American Economic Review, researcher were able to play experiments on financial professionals and found that their behavior to risk changes with the financial environment. When one thinks he is in a market bust period, fear increases which leads to higher risk aversion.  The researchers test this through setting up experimental environments. This is important because the researchers have to separate risk aversion and bust periods from expectations in a bust that asset returns are expected to decline.

The simple charts from the paper show that less is invested in the risky asset if you perceive a bust period. The same applies to an increase in ambiguity. This behavior is the same for those with high and low financial literacy as well as for those with high and low trading frequency.

An increase in risk aversion leads to more extreme market dynamics. When risk aversion increases, investors have to be compensated more for this risk which leads to bigger market moves.  The higher level of risk aversion during market declines can explain some of the asset pricing puzzles that have been plaguing economists for a long time. It also is consistent with how we look at the world.

Caution increases at market extremes. It is in our nature, so systematic models that do not embed changes in risk aversion may be able to gain an edge during these market extremes.