History-Dependent Risk Aversion and the Reinforcement Effect∗

This paper studies history-dependent risk aversion and focuses on a well-documented behavior called the reinforcement effect (RE), which says that people become less riskaverse after a good history than after a bad history. I show that this seemingly anomalous behavior occurs whenever risk preferences are history-dependent (in a nontrivial way) and satisfy monotonicity with respect to first-order stochastic dominance. To study history-dependent risk aversion and the RE formally, I introduce a behaviorally founded model of dynamic choice under risk that generalizes standard discounted expected utility. To illustrate the usefulness of my model, I apply it to the Lucas tree model of asset pricing and draw implications of the RE on asset price dynamics. I find that, compared to history-independent models, the assets are overpriced when the economy is in a good state and are underpriced in a bad state. Moreover, my model generates high, volatile, and predictable asset returns, consistent with empirical evidence.