Dynamics of risk aversion: Stock Market Developments and Emotions

We analyze in a dynamic investment experiment how stock market developments affect risk aversion. In line with the idea of countercyclical risk aversion, we find that participants primed on a bust are significantly more risk averse than participants primed on a boom. Changes in risk aversion are not permanent though: After a bust, participants are only more risk averse at first, but significantly less risk averse shortly afterwards, before risk aversion converges to a stable intermediate level in the long run. After a boom, risk aversion follows the opposite pattern. Using psychophysiological data (pupil dilation, skin conductance, and heart rate variability), we show that booms and busts evoke emotional arousal, which in turn affects risk aversion. Our findings provide important implications on how individual investments and market dynamics are influenced by risk aversion and emotions in response to financial crises.