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1 September 2014 CFA Institute Journal Review

Risk and Reward Preferences under Time Pressure (Digest Summary)

  1. Rich Wiggins, CFA

Theories of choice in economics and finance assume that economic agents have stable preferences that are consistent with maximization of utility under prospect theory or mean–variance optimization. The authors experimentally investigate financial decision making under time pressure and provide evidence that there may be time-varying sensitivities and decreased risk aversion for gains.

What’s Inside?

The authors use a card game to assess individuals’ ability to make decisions under a severe time constraint and try to explain how choices change under differing time constraints.

How Is This Research Useful to Practitioners?

Floor traders and e-traders capitalize on millisecond advantages that require very fast processing of information. The authors examine the speed of trading patterns and how time constraints modulate preferences in decision making under risk. Their results suggest that human decision making under time pressure is not only different from decision making without the pressure but also biased. The authors begin with the notion that decision utility is built over time rather than based on previous experiences given the same choices. The time required to build a decision, however, is not known.

The authors find that when the deliberation time is longer, subjective factors have a different impact on the choices made, which has implications for high-frequency trading. Similarly, decreased variance aversion with decision time has implications for microstructure design (e.g., circuit breakers) and the structure of incentive contracts designed to minimize excessive risk taking. Over- and underpricing occur when markets are extremely fast and traders have to make split-second decisions. Such price impulsiveness implies that, in equilibrium, low-priced securities will be undervalued and high-priced securities will be overvalued. Markets that experience a large volume of trades with little time between trades can, therefore, be expected to mean revert. Average earnings, however, appear to remain the same regardless of the length of the decision-making process, likely because decreased variance aversion is offset by the decreased price impulsiveness.

This subset of decision theory and behavioral choice under uncertainty is unique. The authors’ findings will not be as relevant to decision making under less time pressure—for example, when retail customers purchase financial products or shoppers buy groceries.

How Did the Authors Conduct This Research?

In the study, 43 Stanford undergraduates are presented with the opportunity to buy into a simple card game. The card game starts with a shuffled deck of 10 cards numbered 1–10; 2 cards are drawn consecutively. Subjects win $1 when the second card is higher than the first card. Subjects can buy into the gamble after seeing the first card at a posted price, but they have very little time to decide. They are shown the first card and the price for one, three, or five seconds, after which they have one second to decide whether to buy into the gamble. A 25 cent penalty is charged if no decision is made within the allowed time frame. The total duration of the experiment is approximately an hour and a half. The decision to buy or not at posted prices is one that investors face on a regular basis.

Abstractor’s Viewpoint

The decision theory study of how individuals make financial choices is relatively well established (i.e., choices made based on preferences as well as biases and errors), but the introduction of a time constraint is novel and appropriate. The experimental finance approach to risk-based decision making closely emulates real-life investment scenarios. Behavioral finance assumes that emotions disturb financial decision making, but the new field of neurofinance rejects this conflict between emotion and rationality because emotion can be a key element of rationality. The study enhances decision theory, although it has to be considered that the theory does not necessarily work in the real world, where rules are vague and probabilities are unknown.

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