How do prior Outcomes affect Risk Attitude?

Modelling choice in multi-period asset pricing requires assumptions about how prior outcomes affect risk attitude. We present an experimental study of the influence of prior outcomes on risky choice. We document a strong framing effect. By manipulating the presentation format of the decision problem we can induce increased risk taking following a gain, i.e. the house-money effect (Thaler and Johnson 1990) or, alternatively, increased risk taking following a loss, i.e. escalation of commitment (Staw 1976). Maximization of a value function from prospect theory can explain some of our results. Escalation of commitment in our experiment does not appear to be driven by a need to justify or rationalize the initial decision. [email protected] ∗ We gratefully acknowledge financial support from the Deutsche Forschungsgemeinschaft, through SFB504 and the Graduiertenkolleg at Mannheim, and from the European Commission through the RTN “Understanding Financial Architecture” at Toulouse. We received helpful comments from participants of BDRM 2002 at Chicago, GEW2001 and the Theory Workshop at Mannheim. 1 Universität Mannheim, Lehrstuhl für ABWL, Finanzwirtschaft, insb. Bankbetriebslehre, D-68131 Mannheim. and CEPR, London. 2 Universität Mannheim, Graduiertenkolleg “Allokation auf Finanzund Gütermärkten”, D-68131 Mannheim. [email protected].