An Experimental Study of Risk Adaption and Emotion Differentiation in Dynamic Decision-Making

In this article, we report an experiential study designed to reconcile divergent views in the literature concerning the psychological nature of risk adaptation to a dynamic environment. In particular, we theorize that risk preference varies according to how successfully investors adapt to variations in objective probability conditions. We tested conflicting hypotheses derived from Prospect Theory and Real Option Theory. We also hypothesized that an individual difference variable, negative emotional differentiation, would affect risk adaptation. We again tested conflicting theoretical positions concerning the effect of this variable. In the study, 175 undergraduates completed 20 binary project investment decisions under three objective probability conditions of risky choice winning. Immediate feedback was provided after each trial. We found that negative feedback, including information regarding opportunities missed and wrong risk taking, significantly influenced increased subsequent risk taking. Moreover, participants who increased risk taking, especially under the condition that risky projects have a higher chance of winning, achieved higher returns. We also found that investors who could not differentiate their negative emotions well achieved higher returns than those who could. This suggests that negative emotional differentiation affects investors’ risk-bearing capacity. Finally, we were unable to replicate the “Bowman’s paradox,” a negative relationship between risk and return, which we argue may be a method artifact. We conclude with a discussion of the theoretical and practical implication of our findings.