A behavioral theory of the effect of the risk-free rate on the demand for risky assets

We suggest a behavioral perspective for the demand for risky assets (DRA) in which the risk-free rate affects this demand: the lower the risk-free rate the higher the demand for risky assets. This perspective is based on the idea that changes in return exhibit decreasing sensitivity, that is, the impact of a change diminishes with the distance from the status quo (or reference point). We begin by demonstrating that when the risk-free rate decreases, DRA increases even among sophisticated subjects. We then provide support for our behavioral model in three experiments in which the risk-free rate is manipulated and demand for risky assets is measured. Experiments 1 and 2 rule out alternative explanations, demonstrating that decreasing sensitivity underlies, at least in part, the effect of the risk-free rate on DRA. Experiment 3 demonstrates the role of decreasing sensitivity when returns are presented in terms of monetary payoffs rather than interest rates.