Behavioral Responses to Risk: Effects on Household Financial Decisions, International Portfolio Management, and Output Volatility

Abstract

This dissertation explores how behavioral responses to risk and uncertainty influence the financial decisions of individual households and financial entities involved in allocating external (foreign) capital to domestic investments. The analysis proceeds in two parts: the first chapter investigates how various trait types affect individual financial choices, while the second and third chapters examine how risk perception impacts resource allocation at the aggregate level. These allocation decisions have significant implications for output volatility. The first chapter draws on a large body of experimental psychology evidence indicating that smokers tend to be more risk-tolerant, impatient, and impulsive than non-smokers. As a result, smokers are inclined to make different economic decisions than non-smokers, which often manifests in financial and labor market behaviors. What is missing from this literature is a third category—quitters. The behaviors of this group may be particularly interesting because quitting smoking is a significant challenge, and overcoming this habit may involve unique behavioral and psychological traits that can manifest in actions and outcomes. In this chapter, I use data from the NLSY79 to classify individuals into three groups—smokers, non-smokers, and quitters—and examine how these groups differ in their financial decisions, with potential implications for current and future access to credit. I find that, compared to smokers, the rates of missed payments and bankruptcy are lower among quitters and non-smokers. Notably, in payment habits, quitters appear to be more prudent than non-smokers. The second chapter of the dissertation presents a theoretical model in which financial intermediaries play a central role. These intermediaries receive funds from domestic and foreign lenders and act to maximize depositors' returns. Because a sudden withdrawal of foreign funds (capital flight) reduces returns, intermediaries tend to offset the risk of capital flight by choosing a riskier portfolio, thereby increasing output volatility and lowering growth. This implied relationship sheds light on the literature linking actual capital outflows to macroeconomic volatility, as seen during the Mexican tequila crisis, the Asian financial crisis, and the Russian defaults. The chapter's contribution is to suggest that an increased perceived risk of capital outflow can also lead to higher output volatility and lower growth, even without capital actually flowing out of the country. To test this claim, we construct a cross-country measure from the IMF's Annual Report on Exchange Arrangements and Exchange Restrictions (AREAER) that captures the ease with which foreign capital can be withdrawn from a country. The data suggest that, after accounting for actual capital movements and other factors that influence output volatility, countries that allow unrestricted capital outflows tend to experience higher output volatility. The risk of capital flight from a country depends, unarguably, on how easily capital can be withdrawn. However, in practice, the severity of the threat may also depend on the volume of capital that could be lost due to market disruptions. The third chapter of the dissertation offers more refined support for the theory by treating the United States as the primary source of disruption. In particular, the chapter uses information on cross-country bilateral equity holdings from the IMF's Coordinated Portfolio Investment Survey to construct an index that measures both direct exposure to U.S. capital and indirect exposure to foreign capital from other countries whose capital flows co-move with U.S. flows. The results show that even after controlling for the volatility of realized flows, countries with higher exposure to the U.S. portfolio experience greater output volatility. This pattern is particularly evident among emerging and developing economies.