Do People Disinvest Optimally?

Konstantina Mari and John Hey

Abstract

Dynamic decision problems under risk can be found everywhere in economics, from investment decisions to saving and pension plans. Static decision problems have been extensively investigated experimentally, but tests of dynamic problems are relatively scarce. Here we examine a particular dynamic problem that is of importance in the finance context (where it originated) but which is widely relevant elsewhere. We study the disinvestment decision, in which the DM owns something of value, and must decide when to dispose of it. This problem is of importance in many contexts: if funds are tied up for too long in a poorly performing project, then opportunities for re-investment may be missed. Optimal disinvestment theory started as a component of real options theory, but is relatively ignored by experimentalists. Two recent papers concluded that decision-makers stay in projects longer than that prescribed by the optimal behaviour of a risk-neutral agent. This departure is explained in these papers through risk aversion, but without a formal hypothesis under test. We report here on an experiment that explains the behaviour of the subjects through an estimation of risk-aversion. We also explore an alternative hypothesis – that subjects are myopic. Our results show that few subjects appear to be risk-neutral, many seem to be risk-averse but few are myopic. Our results have importance for many dynamic problems, such as the decision when to sell a house, when to take out a private or a state pension, and when to dispose of any asset, whether financial or physical.