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Evolved attitudes to risk and the demand for equity

Significance An important puzzle in economics concerns the equity premium. Why does anyone hold bonds given the option of holding stocks? Stocks are riskier, but they do much better on average in the long run than bonds, thus generating the equity premium puzzle. Standard economic models of preferences have difficulty accounting for this anomaly on the basis of a level of risk aversion that is consistent with risk-taking behavior elsewhere. We show that considering the biological basis of preferences is fruitful here. Biological evolution predicts that individuals should be more averse to aggregate—shared—risks than they are to risks that are idiosyncratic—personal. Since the stock market involves aggregate risk, this helps to resolve the puzzle. The equity premium puzzle refers to the observation that people invest far less in the stock market than is implied by measures of their risk aversion in other contexts. Here, we argue that light on this puzzle can be shed by the hypothesis that human risk attitudes were at least partly shaped by our evolutionary history. In particular, a simple evolutionary model shows that natural selection will, over the long haul, favor a greater aversion to aggregate than to idiosyncratic risk. We apply this model—via both a static model of portfolio choice and a dynamic model that allows for intertemporal tradeoffs—to show that an aversion to aggregate risk that is derived from biology may help explain the equity premium puzzle. The type of investor favored in our model would indeed invest less in equities than other common observations of risk-taking behavior from outside the stock market would imply, while engaging in reasonable tradeoffs over time.