Precautionary Savings, Loss Aversion, and Risk: Theory and Evidence

We consider a simple, two period, consumption-savings model with future income uncertainty. We  are  interested  in  the  relation  between  the  micro  and  macro  motives  for  dealing  with uncertainty.  These  include  risk  aversion,  loss  aversion,  and  precautionary  savings.  We  provide the relevant theory, followed by empirical tests based on subject-specific savings choices, and the measurement of subject-specific behavioral parameters such as loss aversion and present bias. We predict,  and  show  empirically,  that  loss  aversion  reduces  savings,  and  that  those  who are  more  loss averse are less likely to engage in precautionary savings. Present-bias reduces savings. We also  show  that  decision  makers  save  more  in  response  to  a  mean  preserving  spread  of  future  random  incomes,  and  this  response  is  strengthened  by  loss  aversion.  We  term  this  as  the  loss  aversion-hedging motive.