“Rich or poor, it’s always nice to have money”, as the old saying goes. But rich is relative, as US Congressman John Flemming recently demonstrated in an on-the-air MSNBC interview. He complained about taxes that were so high that “by the time I feed my family, I have maybe $400,000 left over”.

But does more money always make you happy? Recent advances in ‘happiness economics’ suggest that the answers are complicated (Pischke 2011). Our recent work (Koedijk et al 2012) suggests that financial wellbeing is distinct from income.

  • Some high-income earners suffer from a low level of financial wellbeing as their incomes fall short of their aspirations. Such people feel propelled to reach their aspirations by taking risks and show a willingness to bear losses.
  • Some low-income earners feel great from a financial wellbeing perspective as their incomes exceed their aspirations.

Lotteries and insurance policies

“Men will and do take great risks to distinguish themselves even when they know what the risks are”, wrote Milton Friedman and Leonard Savage in 1948. We start new businesses and buy lottery tickets for a chance to reach our aspirations. We do not seek risk. Rather, risk is the price of a chance to reach our aspirations.

Some who aspire to be rich can reasonably expect to reach their aspirations through steady savings invested in safe bonds. But risky investment in stocks, enterprises, or even lottery tickets, offer many of us the only hope of reaching our aspirations, whether millions in bank accounts, ample retirement incomes, or the means to help our children and grandchildren. The Consumer Federation of America (2006) reported that when asked about the most practical way to accumulate several hundred thousand dollars, more than half of surveyed Americans said: “Save something each month for many years”. But more than one in five said “Win the lottery,” and most of these were poor.

Many who bought houses in the boom years of 2006 and 2007 lost them to foreclosures in the years that followed. It is easy to characterise such home buyers as risk-seekers, but aspirations for better lives in homes of their own drove them, and risk was payment for a chance to reach their aspirations.

Such homeowners might well be the unskilled workers that Friedman and Savage described as willing to accept gambles that offer a small chance of lifting them into the “middle” or “upper” classes, even though such gambles are far more likely to make them poor even relative to others in the unskilled workers class.

Members of the upper class often join members of the unskilled workers class in aspirations to distinguish themselves. Rajat Gupta is a member of the hundred-of-millions class who ran McKinsey from 1994 to 2003 and later served as a member of Goldman Sachs' board. Now he stands accused of disclosing inside information to Raj Rajaratnam of the Galleon hedge fund, risking his millions and freedom for a chance to reach the billions class. Rajaratnam understood Gupta's motives in joining the private-equity firm of Kohlberg, Kravis, and Roberts. “My analysis of the situation is he's enamoured with Kravis, and I think he wants to be in that circle,” said Rajaratnam in a telephone conversation played at his trial. “That's a billionaire circle, right? Goldman is like the hundreds-of-millions circle, right?”

People whose incomes fall short of their aspirations feel that they have less money than they need. Such people are burdened by low financial wellbeing. Yet other people with identical incomes enjoy high financial wellbeing, feeling that they have more money than they need. Friedman and Savage’s analysis implies the hypothesis that people burdened by low financial wellbeing are driven to take risks in attempts to reach their aspired financial wellbeing, whereas people enjoying high financial wellbeing are less willing to take such risks.

Low financial wellbeing may propel people not only to be relatively less risk-averse than people with high financial wellbeing, but also to be less loss-averse. People who are relatively less loss-averse care relatively less about avoiding financial losses than about reaping financial gains. Such people might act as hopeful and optimistic people, motivated to perceive higher probabilities of gains and lower probabilities of losses than objective probabilities. Friedman and Savage quoted Adam Smith about the “presumptuous hope of success” that entices “so many adventurers into ... hazardous trades ...”. Conversely, people who are relatively loss-averse care relatively more about avoiding financial losses than about reaping financial gains. Such people might act as fearful and pessimistic people, motivated to perceive higher probabilities of losses and lower probabilities of gains than objective probabilities. This implies a second hypothesis, that people with relatively low financial wellbeing are relatively less loss-averse than people with relatively high financial wellbeing.

Not all people in the unskilled workers class seek to ‘distinguish themselves’ by rising into the middle or upper class, and not all people in the hundreds-of-millions class seek to distinguish themselves by rising into the billions class. People who seek to distinguish themselves are competitive and status-seeking people. This implies a third hypothesis, that relatively competitive and status-seeking people are less risk-averse and less loss-averse than people who are less competitive and status-seeking. In Koedijk et al (2012), we find support for these three hypotheses in data from a subsection of the DNB Household Survey conducted in 2010, and a survey sponsored by the Dutch National Bank and administered by CentER at Tilburg University. In addition, we have a sample of 1,842 Dutch households from a survey sponsored by the Dutch National Bank and administered by CentER at Tilburg University. The survey provides information about the economic and psychological determinants of households' decision-making. CentER includes data about income, marital status, number of children, and education.

Hypotheses and findings

We offer three hypotheses:

Hypothesis 1: People with relatively low financial wellbeing have relatively low risk-aversion.

Hypothesis 2: People with relatively low financial wellbeing have relatively low loss-aversion.

Hypothesis 3: Competitive and status-seeking people are less risk-averse and less loss-averse than people who are less competitive and less status-seeking.

We find that people with relatively high incomes are more likely to perceive themselves as enjoying high financial wellbeing than people with relatively low incomes. Yet there is wide variation of wellbeing at similar levels of income. Indeed, some people at the highest levels of income perceive themselves as having lower financial wellbeing than people at the lowest levels of income.

We also find that financial wellbeing increases with education and age. But there is no statistically significant relationship between financial wellbeing and gender, competitiveness, or status-seeking.

We find, consistent with our first hypothesis that people who enjoy relatively high financial wellbeing tend to be relatively risk-averse. We also find, consistent with the third hypothesis, that competitive and status-seeking people are likely to be relatively less risk-averse than people who are not as competitive or status-seeking. Relatively old people are more likely to be risk-averse than relatively young people, and women tend to be more risk-averse than men. Yet there is no statistically significant relation between risk-aversion and income or education.

We find, consistent with our second hypothesis, a positive and statistically significant relation between loss-aversion and financial wellbeing. We find a negative and statistically significant relationship between loss-aversion and status-seeking, consistent with our third hypothesis, but the relationship between loss-aversion and competitiveness is positive, inconsistent with our third hypothesis, even if not statistically significant.

There is a positive and statistically significant relationship between loss-aversion and age, and women are more loss-averse than men at a statistically significant level. Yet there is no statistically significant relationship between loss-aversion and income or education.

Our findings imply that people with relatively low income can enjoy financial wellbeing as high as people with high incomes as long as their aspirations do not exceed their incomes. A crisis, such as one in 2008, is likely to tamp aspirations along with incomes, mitigating its effect on financial wellbeing. Conversely, economic liberalisation, as in China, might decrease financial wellbeing if aspirations rise faster than incomes.

References

Consumer Federation of America (2006) How Americans View Personal Wealth vs. How Financial Planners View This Wealth, press release.

Edwards, David (2011). “Tea party Rep.: Only $400,000 left after ‘I feed my family’”, rawstory.com

Friedman, Milton & Leonard. J. Savage, (1948) The Utility Analysis of Choices Involving Risk." Journal of Political Economy, LVI (August), 279-304.

Koedijk , Kees, Rachel A J Pownall , Meir Statman (2012) “Aspirations, Well-being, Risk-Aversion and Loss-Aversion”, CEPR Discussion Paper 8904.

Pischke, Jörn-Steffen (2011), Does income cause happiness: Evidence from industrial wage dispersion, VoxEU.org, 3 June.

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