Risk aversion

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Risk aversion (red) contrasted to risk neutrality (yellow) and risk loving (orange) in different settings. Left graph: A risk averse utility function is concave (from below), while a risk loving utility function is convex. Middle graph: In standard deviation-expected value space, risk averse indifference curves are upward sloped. Right graph: With fixed probabilities of two alternative states 1 and 2, risk averse indifference curves over pairs of state-contingent outcomes are convex. Risikoeinstellung.svg
Risk aversion (red) contrasted to risk neutrality (yellow) and risk loving (orange) in different settings. Left graph: A risk averse utility function is concave (from below), while a risk loving utility function is convex. Middle graph: In standard deviation-expected value space, risk averse indifference curves are upward sloped. Right graph: With fixed probabilities of two alternative states 1 and 2, risk averse indifference curves over pairs of state-contingent outcomes are convex.

In economics and finance, risk aversion is the tendency of people to prefer outcomes with low uncertainty to those outcomes with high uncertainty, even if the average outcome of the latter is equal to or higher in monetary value than the more certain outcome. [1] Risk aversion explains the inclination to agree to a situation with a more predictable, but possibly lower payoff, rather than another situation with a highly unpredictable, but possibly higher payoff. For example, a risk-averse investor might choose to put their money into a bank account with a low but guaranteed interest rate, rather than into a stock that may have high expected returns, but also involves a chance of losing value.

Contents

Example

Riskpremium1.png
Utility function of a risk-averse (risk-avoiding) individual
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Utility function of a risk-neutral individual
Riskpremium3.png
Utility function of a risk-loving (risk-seeking) individual
CECertainty equivalent; E(U(W))Expected value of the utility (expected utility) of the uncertain payment W; E(W) – Expected value of the uncertain payment; U(CE)Utility of the certainty equivalent; U(E(W)) – Utility of the expected value of the uncertain payment; U(W0) – Utility of the minimal payment; U(W1) – Utility of the maximal payment; W0 – Minimal payment; W1 – Maximal payment; RPRisk premium

A person is given the choice between two scenarios: one with a guaranteed payoff, and one with a risky payoff with same average value. In the former scenario, the person receives $50. In the uncertain scenario, a coin is flipped to decide whether the person receives $100 or nothing. The expected payoff for both scenarios is $50, meaning that an individual who was insensitive to risk would not care whether they took the guaranteed payment or the gamble. However, individuals may have different risk attitudes. [2] [3] [4]

A person is said to be:

The average payoff of the gamble, known as its expected value, is $50. The smallest dollar amount that an individual would be indifferent to spending on a gamble or guarantee is called the certainty equivalent, which is also used as a measure of risk aversion. An individual that is risk averse has a certainty equivalent that is smaller than the prediction of uncertain gains. The risk premium is the difference between the expected value and the certainty equivalent. For risk-averse individuals, risk premium is positive, for risk-neutral persons it is zero, and for risk-loving individuals their risk premium is negative.

Utility of money

In expected utility theory, an agent has a utility function u(c) where c represents the value that he might receive in money or goods (in the above example c could be $0 or $40 or $100).

The utility function u(c) is defined only up to positive affine transformation – in other words, a constant could be added to the value of u(c) for all c, and/or u(c) could be multiplied by a positive constant factor, without affecting the conclusions.

An agent possesses risk aversion if and only if the utility function is concave. For instance u(0) could be 0, u(100) might be 10, u(40) might be 5, and for comparison u(50) might be 6.

The expected utility of the above bet (with a 50% chance of receiving 100 and a 50% chance of receiving 0) is

,

and if the person has the utility function with u(0)=0, u(40)=5, and u(100)=10 then the expected utility of the bet equals 5, which is the same as the known utility of the amount 40. Hence the certainty equivalent is 40.

The risk premium is ($50 minus $40)=$10, or in proportional terms

or 25% (where $50 is the expected value of the risky bet: (). This risk premium means that the person would be willing to sacrifice as much as $10 in expected value in order to achieve perfect certainty about how much money will be received. In other words, the person would be indifferent between the bet and a guarantee of $40, and would prefer anything over $40 to the bet.

In the case of a wealthier individual, the risk of losing $100 would be less significant, and for such small amounts his utility function would be likely to be almost linear. For instance, if u(0) = 0 and u(100) = 10, then u(40) might be 4.02 and u(50) might be 5.01.

The utility function for perceived gains has two key properties: an upward slope, and concavity. (i) The upward slope implies that the person feels that more is better: a larger amount received yields greater utility, and for risky bets the person would prefer a bet which is first-order stochastically dominant over an alternative bet (that is, if the probability mass of the second bet is pushed to the right to form the first bet, then the first bet is preferred). (ii) The concavity of the utility function implies that the person is risk averse: a sure amount would always be preferred over a risky bet having the same expected value; moreover, for risky bets the person would prefer a bet which is a mean-preserving contraction of an alternative bet (that is, if some of the probability mass of the first bet is spread out without altering the mean to form the second bet, then the first bet is preferred).

Measures of risk aversion under expected utility theory

There are multiple measures of the risk aversion expressed by a given utility function. Several functional forms often used for utility functions are expressed in terms of these measures.

Absolute risk aversion

The higher the curvature of , the higher the risk aversion. However, since expected utility functions are not uniquely defined (are defined only up to affine transformations), a measure that stays constant with respect to these transformations is needed rather than just the second derivative of . One such measure is the Arrow–Pratt measure of absolute risk aversion (ARA), after the economists Kenneth Arrow and John W. Pratt, [5] [6] also known as the coefficient of absolute risk aversion, defined as

where and denote the first and second derivatives with respect to of . For example, if so and then Note how does not depend on and so affine transformations of do not change it.

The following expressions relate to this term:

The solution to this differential equation (omitting additive and multiplicative constant terms, which do not affect the behavior implied by the utility function) is:

where and . Note that when , this is CARA, as , and when , this is CRRA (see below), as . See [7]

and this can hold only if . Therefore, DARA implies that the utility function is positively skewed; that is, . [8] Analogously, IARA can be derived with the opposite directions of inequalities, which permits but does not require a negatively skewed utility function (). An example of a DARA utility function is , with , while , with would represent a quadratic utility function exhibiting IARA.

Relative risk aversion

The Arrow–Pratt measure of relative risk aversion (RRA) or coefficient of relative risk aversion is defined as [11]

.

Unlike ARA whose units are in $−1, RRA is a dimension-less quantity, which allows it to be applied universally. Like for absolute risk aversion, the corresponding terms constant relative risk aversion (CRRA) and decreasing/increasing relative risk aversion (DRRA/IRRA) are used. This measure has the advantage that it is still a valid measure of risk aversion, even if the utility function changes from risk averse to risk loving as c varies, i.e. utility is not strictly convex/concave over all c. A constant RRA implies a decreasing ARA, but the reverse is not always true. As a specific example of constant relative risk aversion, the utility function implies RRA = 1.

In intertemporal choice problems, the elasticity of intertemporal substitution often cannot be disentangled from the coefficient of relative risk aversion. The isoelastic utility function

exhibits constant relative risk aversion with and the elasticity of intertemporal substitution . When using l'Hôpital's rule shows that this simplifies to the case of log utility,u(c) = log c, and the income effect and substitution effect on saving exactly offset.

A time-varying relative risk aversion can be considered. [12]

Implications of increasing/decreasing absolute and relative risk aversion

The most straightforward implications of increasing or decreasing absolute or relative risk aversion, and the ones that motivate a focus on these concepts, occur in the context of forming a portfolio with one risky asset and one risk-free asset. [5] [6] If the person experiences an increase in wealth, he/she will choose to increase (or keep unchanged, or decrease) the number of dollars of the risky asset held in the portfolio if absolute risk aversion is decreasing (or constant, or increasing). Thus economists avoid using utility functions such as the quadratic, which exhibit increasing absolute risk aversion, because they have an unrealistic behavioral implication.

Similarly, if the person experiences an increase in wealth, he/she will choose to increase (or keep unchanged, or decrease) the fraction of the portfolio held in the risky asset if relative risk aversion is decreasing (or constant, or increasing).

In one model in monetary economics, an increase in relative risk aversion increases the impact of households' money holdings on the overall economy. In other words, the more the relative risk aversion increases, the more money demand shocks will impact the economy. [13]

Portfolio theory

In modern portfolio theory, risk aversion is measured as the additional expected reward an investor requires to accept additional risk. If an investor is risk-averse, they will invest in multiple uncertain assets, but only when the predicted return on a portfolio that is uncertain is greater than the predicted return on one that is not uncertain will the investor will prefer the former. [1] Here, the risk-return spectrum is relevant, as it results largely from this type of risk aversion. Here risk is measured as the standard deviation of the return on investment, i.e. the square root of its variance. In advanced portfolio theory, different kinds of risk are taken into consideration. They are measured as the n-th root of the n-th central moment. The symbol used for risk aversion is A or An.

Limitations of expected utility treatment of risk aversion

Using expected utility theory's approach to risk aversion to analyze small stakes decisions has come under criticism. Matthew Rabin has showed that a risk-averse, expected-utility-maximizing individual who,

from any initial wealth level [...] turns down gambles where she loses $100 or gains $110, each with 50% probability [...] will turn down 50–50 bets of losing $1,000 or gaining any sum of money. [14]

Rabin criticizes this implication of expected utility theory on grounds of implausibility—individuals who are risk averse for small gambles due to diminishing marginal utility would exhibit extreme forms of risk aversion in risky decisions under larger stakes. One solution to the problem observed by Rabin is that proposed by prospect theory and cumulative prospect theory, where outcomes are considered relative to a reference point (usually the status quo), rather than considering only the final wealth.

Another limitation is the reflection effect, which demonstrates the reversing of risk aversion. This effect was first presented by Kahneman and Tversky as a part of the prospect theory, in the behavioral economics domain. The reflection effect is an identified pattern of opposite preferences between negative as opposed to positive prospects: people tend to avoid risk when the gamble is between gains, and to seek risks when the gamble is between losses. [15] For example, most people prefer a certain gain of 3,000 to an 80% chance of a gain of 4,000. When posed the same problem, but for losses, most people prefer an 80% chance of a loss of 4,000 to a certain loss of 3,000.

The reflection effect (as well as the certainty effect) is inconsistent with the expected utility hypothesis. It is assumed that the psychological principle which stands behind this kind of behavior is the overweighting of certainty. Options which are perceived as certain are over-weighted relative to uncertain options. This pattern is an indication of risk-seeking behavior in negative prospects and eliminates other explanations for the certainty effect such as aversion for uncertainty or variability. [15]

The initial findings regarding the reflection effect faced criticism regarding its validity, as it was claimed that there are insufficient evidence to support the effect on the individual level. Subsequently, an extensive investigation revealed its possible limitations, suggesting that the effect is most prevalent when either small or large amounts and extreme probabilities are involved. [16] [17]

In the brain

Attitudes towards risk have attracted the interest of the field of neuroeconomics and behavioral economics. A 2009 study by Christopoulos et al. suggested that the activity of a specific brain area (right inferior frontal gyrus) correlates with risk aversion, with more risk averse participants (i.e. those having higher risk premia) also having higher responses to safer options. [18] This result coincides with other studies, [18] [19] that show that neuromodulation of the same area results in participants making more or less risk averse choices, depending on whether the modulation increases or decreases the activity of the target area.

Public understanding and risk in social activities

In the real world, many government agencies, e.g. Health and Safety Executive, are fundamentally risk-averse in their mandate. This often means that they demand (with the power of legal enforcement) that risks be minimized, even at the cost of losing the utility of the risky activity. It is important to consider the opportunity cost when mitigating a risk; the cost of not taking the risky action. Writing laws focused on the risk without the balance of the utility may misrepresent society's goals. The public understanding of risk, which influences political decisions, is an area which has recently been recognised as deserving focus. In 2007 Cambridge University initiated the Winton Professorship of the Public Understanding of Risk, a role described as outreach rather than traditional academic research by the holder, David Spiegelhalter. [20]

Children

Children's services such as schools and playgrounds have become the focus of much risk-averse planning, meaning that children are often prevented from benefiting from activities that they would otherwise have had. Many playgrounds have been fitted with impact-absorbing matting surfaces. However, these are only designed to save children from death in the case of direct falls on their heads and do not achieve their main goals. [21] They are expensive, meaning that less resources are available to benefit users in other ways (such as building a playground closer to the child's home, reducing the risk of a road traffic accident on the way to it), and—some argue—children may attempt more dangerous acts, with confidence in the artificial surface. Shiela Sage, an early years school advisor, observes "Children who are only ever kept in very safe places, are not the ones who are able to solve problems for themselves. Children need to have a certain amount of risk taking ... so they'll know how to get out of situations." [22] [ citation needed ]

Game shows and investments

One experimental study with student-subject playing the game of the TV show Deal or No Deal finds that people are more risk averse in the limelight than in the anonymity of a typical behavioral laboratory. In the laboratory treatments, subjects made decisions in a standard, computerized laboratory setting as typically employed in behavioral experiments. In the limelight treatments, subjects made their choices in a simulated game show environment, which included a live audience, a game show host, and video cameras. [23] In line with this, studies on investor behavior find that investors trade more and more speculatively after switching from phone-based to online trading [24] [25] and that investors tend to keep their core investments with traditional brokers and use a small fraction of their wealth to speculate online. [26]

See also

Related Research Articles

Within economics, the concept of utility is used to model worth or value. Its usage has evolved significantly over time. The term was introduced initially as a measure of pleasure or happiness within the theory of utilitarianism by moral philosophers such as Jeremy Bentham and John Stuart Mill. The term has been adapted and reapplied within neoclassical economics, which dominates modern economic theory, as a utility function that represents a single consumer's preference ordering over a choice set but is not comparable across consumers. This concept of utility is personal and is based on choice rather than on the pleasure received, and so is more rigorously specified than the original concept but makes it less useful for ethical decisions.

Capital asset pricing model

In finance, the capital asset pricing model (CAPM) is a model used to determine a theoretically appropriate required rate of return of an asset, to make decisions about adding assets to a well-diversified portfolio.

Prospect theory Theory of behavioral economics and behavioral finance

Prospect theory is a theory of behavioral economics and behavioral finance that was developed by Daniel Kahneman and Amos Tversky in 1979. The theory was cited in the decision to award Kahneman the 2002 Nobel Memorial Prize in Economics.

In economics, contract theory studies how economic actors can and do construct contractual arrangements, generally in the presence of information asymmetry. Because of its connections with both agency and incentives, contract theory is often categorized within a field known as Law and economics. One prominent application of it is the design of optimal schemes of managerial compensation. In the field of economics, the first formal treatment of this topic was given by Kenneth Arrow in the 1960s. In 2016, Oliver Hart and Bengt R. Holmström both received the Nobel Memorial Prize in Economic Sciences for their work on contract theory, covering many topics from CEO pay to privatizations. Holmström (MIT) focused more on the connection between incentives and risk, while Hart (Harvard) on the unpredictability of the future that creates holes in contracts.

In economics and finance, risk neutral preferences are preferences that are neither risk averse nor risk seeking. A risk neutral party's decisions are not affected by the degree of uncertainty in a set of outcomes, so a risk neutral party is indifferent between choices with equal expected payoffs even if one choice is riskier. For example, if offered either or a chance each of and , a risk neutral person would have no preference. In contrast, a risk averse person would prefer the first offer, while a risk seeking person would prefer the second.

The expected utility hypothesis is a popular concept in economics that serves as a reference guide for decisions when the payoff is uncertain. The theory recommends which option rational individuals should choose in a complex situation, based on their risk appetite and preferences.

The equity premium puzzle refers to the inability of an important class of economic models to explain the average equity risk premium (ERP) provided by a diversified portfolio of U.S. equities over that of U.S. Treasury Bills, which has been observed for more than 100 years.

The Allais paradox is a choice problem designed by Maurice Allais (1953) to show an inconsistency of actual observed choices with the predictions of expected utility theory.

In accounting, finance, and economics, a risk-seeker or risk-lover is a person who has a preference for risk.

In decision theory and economics, ambiguity aversion is a preference for known risks over unknown risks. An ambiguity-averse individual would rather choose an alternative where the probability distribution of the outcomes is known over one where the probabilities are unknown. This behavior was first introduced through the Ellsberg paradox.

Cumulative prospect theory

Cumulative prospect theory (CPT) is a model for descriptive decisions under risk and uncertainty which was introduced by Amos Tversky and Daniel Kahneman in 1992. It is a further development and variant of prospect theory. The difference between this version and the original version of prospect theory is that weighting is applied to the cumulative probability distribution function, as in rank-dependent expected utility theory but not applied to the probabilities of individual outcomes. In 2002, Daniel Kahneman received the Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel for his contributions to behavioral economics, in particular the development of Cumulative Prospect Theory (CPT).

Merton's portfolio problem is a well known problem in continuous-time finance and in particular intertemporal portfolio choice. An investor must choose how much to consume and must allocate his wealth between stocks and a risk-free asset so as to maximize expected utility. The problem was formulated and solved by Robert C. Merton in 1969 both for finite lifetimes and for the infinite case. Research has continued to extend and generalize the model to include factors like transaction costs and bankruptcy.

Exponential utility

In economics and finance, exponential utility is a specific form of the utility function, used in some contexts because of its convenience when risk is present, in which case expected utility is maximized. Formally, exponential utility is given by:

Isoelastic utility

In economics, the isoelastic function for utility, also known as the isoelastic utility function, or power utility function is used to express utility in terms of consumption or some other economic variable that a decision-maker is concerned with. The isoelastic utility function is a special case of hyperbolic absolute risk aversion and at the same time is the only class of utility functions with constant relative risk aversion, which is why it is also called the CRRA utility function.

Goals-Based Investing or Goal-Driven Investing is the use of financial markets to fund goals within a specified period of time. Traditional portfolio construction balances expected portfolio variance with return and uses a risk aversion metric to select the optimal mix of investments. By contrast, GBI optimizes an investment mix to minimize the probability of failing to achieve a minimum wealth level within a set period of time.

In decision theory, economics, and finance, a two-moment decision model is a model that describes or prescribes the process of making decisions in a context in which the decision-maker is faced with random variables whose realizations cannot be known in advance, and in which choices are made based on knowledge of two moments of those random variables. The two moments are almost always the mean—that is, the expected value, which is the first moment about zero—and the variance, which is the second moment about the mean.

In finance, economics, and decision theory, hyperbolic absolute risk aversion (HARA) refers to a type of risk aversion that is particularly convenient to model mathematically and to obtain empirical predictions from. It refers specifically to a property of von Neumann–Morgenstern utility functions, which are typically functions of final wealth, and which describe a decision-maker's degree of satisfaction with the outcome for wealth. The final outcome for wealth is affected both by random variables and by decisions. Decision-makers are assumed to make their decisions so as to maximize the expected value of the utility function.

In mathematical economics, an isoelastic function, sometimes constant elasticity function, is a function that exhibits a constant elasticity, i.e. has a constant elasticity coefficient. The elasticity is the ratio of the percentage change in the dependent variable to the percentage causative change in the independent variable, in the limit as the changes approach zero in magnitude.

Intertemporal portfolio choice is the process of allocating one's investable wealth to various assets, especially financial assets, repeatedly over time, in such a way as to optimize some criterion. The set of asset proportions at any time defines a portfolio. Since the returns on almost all assets are not fully predictable, the criterion has to take financial risk into account. Typically the criterion is the expected value of some concave function of the value of the portfolio after a certain number of time periods—that is, the expected utility of final wealth. Alternatively, it may be a function of the various levels of goods and services consumption that are attained by withdrawing some funds from the portfolio after each time period.

Risk aversion is a preference for a sure outcome over a gamble with higher or equal expected value. Conversely, the rejection of a sure thing in favor of a gamble of lower or equal expected value is known as risk-seeking behavior.

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