![Risikoeinstellung](https://upload.wikimedia.org/wikipedia/commons/7/7a/Risikoeinstellung.svg)
In
economics
Economics () is the social science that studies the Production (economics), production, distribution (economics), distribution, and Consumption (economics), consumption of goods and services.
Economics focuses on the behaviour and intera ...
and
finance
Finance is the study and discipline of money, currency and capital assets. It is related to, but not synonymous with economics, the study of production, distribution, and consumption of money, assets, goods and services (the discipline of fina ...
, risk aversion is the tendency of people to prefer outcomes with low
uncertainty
Uncertainty refers to epistemic situations involving imperfect or unknown information. It applies to predictions of future events, to physical measurements that are already made, or to the unknown. Uncertainty arises in partially observable or ...
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.
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
A bank is a financial institution that accepts deposits from the public and creates a demand deposit while simultaneously making loans. Lending activities can be directly performed by the bank or indirectly through capital markets.
Because ...
account with a low but guaranteed interest rate, rather than into a
stock
In finance, stock (also capital stock) consists of all the shares by which ownership of a corporation or company is divided.Longman Business English Dictionary: "stock - ''especially AmE'' one of the shares into which ownership of a company ...
that may have high expected returns, but also involves a chance of losing value.
Example
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.
A person is said to be:
* risk averse (or risk avoiding) - if they would accept a certain payment (
certainty equivalent
A risk premium is a measure of excess return that is required by an individual to compensate being subjected to an increased level of risk. It is used widely in finance and economics, the general definition being the expected risky Rate of retur ...
) of less than $50 (for example, $40), rather than taking the gamble and possibly receiving nothing.
*
risk neutral
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 indiff ...
– if they are indifferent between the bet and a certain $50 payment.
*
risk loving
In accounting, finance, and economics
Economics () is the social science that studies the production, distribution, and consumption of goods and services.
Economics focuses on the behaviour and interactions of economic agents and ho ...
(or risk seeking) – if they would accept the bet even when the guaranteed payment is more than $50 (for example, $60).
The average payoff of the gamble, known as its
expected value
In probability theory, the expected value (also called expectation, expectancy, mathematical expectation, mean, average, or first moment) is a generalization of the weighted average. Informally, the expected value is the arithmetic mean of a l ...
, is $50. The smallest dollar amount that an individual would be indifferent to spending on a gamble or guarantee is called the
certainty equivalent
A risk premium is a measure of excess return that is required by an individual to compensate being subjected to an increased level of risk. It is used widely in finance and economics, the general definition being the expected risky Rate of retur ...
, 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
A risk premium is a measure of excess return that is required by an individual to compensate being subjected to an increased level of risk. It is used widely in finance and economics, the general definition being the expected risky return less t ...
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 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 the ...
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 Two Mathematical object, mathematical objects ''a'' and ''b'' are called equal up to an equivalence relation ''R''
* if ''a'' and ''b'' are related by ''R'', that is,
* if ''aRb'' holds, that is,
* if the equivalence classes of ''a'' and ''b'' wi ...
positive
affine transformation
In Euclidean geometry, an affine transformation or affinity (from the Latin, ''affinis'', "connected with") is a geometric transformation that preserves lines and parallelism, but not necessarily Euclidean distances and angles.
More generally, ...
– 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
Concave or concavity may refer to:
Science and technology
* Concave lens
* Concave mirror
Mathematics
* Concave function, the negative of a convex function
* Concave polygon, a polygon which is not convex
* Concave set
* The concavity
In ca ...
. 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 In probability and statistics, a mean-preserving spread (MPS) is a change from one probability distribution A to another probability distribution B, where B is formed by spreading out one or more portions of A's probability density function or pr ...
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 various measures of the risk aversion expressed by those given utility function. Several functional forms often used for utility functions are represented by 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
In Euclidean geometry, an affine transformation or affinity (from the Latin, ''affinis'', "connected with") is a geometric transformation that preserves lines and parallelism, but not necessarily Euclidean distances and angles.
More generally, ...
), 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
Kenneth Joseph Arrow (23 August 1921 – 21 February 2017) was an American economist, mathematician, writer, and political theorist. He was the joint winner of the Nobel Memorial Prize in Economic Sciences with John Hicks in 1972.
In economics ...
and
John W. Pratt
John Winsor Pratt (born 1931) is Emeritus William Ziegler (industrialist), William Ziegler professor business administration at Harvard University. His former education was conducted at Princeton University, Princeton and Stanford University, Stan ...
,
[ Reprinted in]
''Essays in the Theory of Risk Bearing''
Markham Publ. Co., Chicago, 1971, 90–109. 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:
*
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 (sometimes referred to as uncertainty) is present, in which case expected utility is maximized. For ...
of the form
is unique in exhibiting ''constant absolute risk aversion'' (CARA):
is constant with respect to ''c''.
*
Hyperbolic absolute risk aversion In finance, economics, and decision theory, hyperbolic absolute risk aversion (HARA) (Chapter I of his Ph.D. dissertation; Chapter 5 in his ''Continuous-Time Finance'').Ljungqvist & Sargent, Recursive Macroeconomic Theory, MIT Press, Second Edition ...
(HARA) is the most general class of utility functions that are usually used in practice (specifically, CRRA (constant relative risk aversion, see below), CARA (constant absolute risk aversion), and quadratic utility all exhibit HARA and are often used because of their mathematical tractability). A utility function exhibits HARA if its absolute risk aversion is a
hyperbolic function
In mathematics, hyperbolic functions are analogues of the ordinary trigonometric functions, but defined using the hyperbola rather than the circle. Just as the points form a circle with a unit radius, the points form the right half of the u ...
, namely
:
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
* ''Decreasing/increasing absolute risk aversion'' (DARA/IARA) is present if
is decreasing/increasing. Using the above definition of ARA, the following inequality holds for DARA:
:
and this can hold only if
. Therefore, DARA implies that the utility function is positively skewed; that is,
. 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.
*Experimental and empirical evidence is mostly consistent with decreasing absolute risk aversion.
* Contrary to what several empirical studies have assumed, wealth is not a good proxy for risk aversion when studying risk sharing in a principal-agent setting. Although
is monotonic in wealth under either DARA or IARA and constant in wealth under CARA, tests of contractual risk sharing relying on wealth as a proxy for absolute risk aversion are usually not identified.
Relative risk aversion
The Arrow–Pratt measure of relative risk aversion (RRA) or coefficient of relative risk aversion is defined as
:
.
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 Intertemporal choice is the process by which people make decisions about what and how much to do at various points in time, when choices at one time influence the possibilities available at other points in time. These choices are influenced by the ...
problems, the
elasticity of intertemporal substitution Elasticity of intertemporal substitution (or intertemporal elasticity of substitution, EIS, IES) is a measure of responsiveness of the growth rate of consumption to the real interest rate. If the real interest rate rises, current consumption may de ...
often cannot be disentangled from the coefficient of relative risk aversion. The
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 ...
function
:
exhibits constant relative risk aversion with
and the elasticity of intertemporal substitution
. When
using
l'Hôpital's rule
In calculus, l'Hôpital's rule or l'Hospital's rule (, , ), also known as Bernoulli's rule, is a theorem which provides a technique to evaluate limits of indeterminate forms. Application (or repeated application) of the rule often converts an i ...
shows that this simplifies to the case of ''log utility,'' ''u''(''c'') = log ''c'', and the
income effect
The theory of consumer choice is the branch of microeconomics that relates preferences to consumption expenditures and to consumer demand curves. It analyzes how consumers maximize the desirability of their consumption as measured by their pref ...
and
substitution effect
In economics and particularly in consumer choice theory, the substitution effect is one component of the effect of a change in the price of a good upon the amount of that good demanded by a consumer, the other being the income effect.
When a g ...
on saving exactly offset.
A time-varying relative risk aversion can be considered.
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.
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
A model is an informative representation of an object, person or system. The term originally denoted the Plan_(drawing), plans of a building in late 16th-century English, and derived via French and Italian ultimately from Latin ''modulus'', a mea ...
in
monetary economics
Monetary economics is the branch of economics that studies the different competing theories of money: it provides a framework for analyzing money and considers its functions (such as medium of exchange, store of value and unit of account), and it ...
, 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.
Portfolio theory
In
modern portfolio theory
Modern portfolio theory (MPT), or mean-variance analysis, is a mathematical framework for assembling a portfolio of assets such that the expected return is maximized for a given level of risk. It is a formalization and extension of diversificatio ...
, 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.
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
In statistics, the standard deviation is a measure of the amount of variation or dispersion of a set of values. A low standard deviation indicates that the values tend to be close to the mean (also called the expected value) of the set, while ...
of the return on investment, i.e. the
square root
In mathematics, a square root of a number is a number such that ; in other words, a number whose ''square'' (the result of multiplying the number by itself, or ⋅ ) is . For example, 4 and −4 are square roots of 16, because .
E ...
of its
variance
In probability theory and statistics, variance is the expectation of the squared deviation of a random variable from its population mean or sample mean. Variance is a measure of dispersion, meaning it is a measure of how far a set of numbers ...
. In advanced portfolio theory, different kinds of risk are taken into consideration. They are measured as the
n-th root
In mathematics, a radicand, also known as an nth root, of a number ''x'' is a number ''r'' which, when raised to the power ''n'', yields ''x'':
:r^n = x,
where ''n'' is a positive integer, sometimes called the ''degree'' of the root. A root ...
of the n-th
central moment
In probability theory and statistics, a central moment is a moment of a probability distribution of a random variable about the random variable's mean; that is, it is the expected value of a specified integer power of the deviation of the random ...
. The symbol used for risk aversion is A or A
n.
:
:
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
Matthew Joel Rabin (born December 27, 1963) is the Pershing Square Professor of Behavioral Economics in the Harvard Economics Department and Harvard Business School. Rabin's research focuses primarily on incorporating psychologically more reali ...
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.''
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
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.
Based ...
and
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 (Tversky, Kahneman, 1992). It is a further development and variant of prospect theor ...
, 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
Daniel Kahneman (; he, דניאל כהנמן; born March 5, 1934) is an Israeli-American psychologist and economist notable for his work on the psychology of judgment and decision-making, as well as behavioral economics, for which he was awarde ...
and
Tversky as a part of the
prospect theory
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.
Based ...
, in the
behavioral economics
Behavioral economics studies the effects of psychological, cognitive, emotional, cultural and social factors on the decisions of individuals or institutions, such as how those decisions vary from those implied by classical economic theory. ...
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.
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
The certainty effect is the psychological effect resulting from the reduction of probability from certain to probable . It is an idea introduced in prospect theory.
Normally a reduction in the probability of winning a reward (e.g., a reduction f ...
) 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.
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.
In the brain
Attitudes towards risk have attracted the interest of the field of
neuroeconomics
Neuroeconomics is an interdisciplinary field that seeks to explain human decision-making, the ability to process multiple alternatives and to follow through on a plan of action. It studies how economic behavior can shape our understanding of the ...
and
behavioral economics
Behavioral economics studies the effects of psychological, cognitive, emotional, cultural and social factors on the decisions of individuals or institutions, such as how those decisions vary from those implied by classical economic theory. ...
. 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.
This result coincides with other studies,
[ that show that ]neuromodulation
Neuromodulation is the physiological process by which a given neuron uses one or more chemicals to regulate diverse populations of neurons. Neuromodulators typically bind to metabotropic, G-protein coupled receptors (GPCRs) to initiate a second ...
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
The Health and Safety Executive (HSE) is a UK government agency responsible for the encouragement, regulation and enforcement of workplace health, safety and welfare, and for research into occupational risks in Great Britain. It is a non-depar ...
, 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
In microeconomic theory, the opportunity cost of a particular activity is the value or benefit given up by engaging in that activity, relative to engaging in an alternative activity. More effective it means if you chose one activity (for example ...
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
, mottoeng = Literal: From here, light and sacred draughts.
Non literal: From this place, we gain enlightenment and precious knowledge.
, established =
, other_name = The Chancellor, Masters and Schola ...
initiated the Winton Professorship of the Public Understanding of Risk
The Winton Professorship of the Public Understanding of Risk is a professorship within the Statistical Laboratory of the University of Cambridge
, mottoeng = Literal: From here, light and sacred draughts.
Non literal: From thi ...
, a role described as outreach rather than traditional academic research by the holder, David Spiegelhalter
Sir David John Spiegelhalter (born 16 August 1953) is a British statistician and a Fellow of Churchill College, Cambridge. From 2007 to 2018 he was Winton Professor of the Public Understanding of Risk in the Statistical Laboratory at the U ...
.
Children
Children's services such as school
A school is an educational institution designed to provide learning spaces and learning environments for the teaching of students under the direction of teachers. Most countries have systems of formal education, which is sometimes compuls ...
s and playground
A playground, playpark, or play area is a place designed to provide an environment for children that facilitates play, typically outdoors. While a playground is usually designed for children, some are designed for other age groups, or people ...
s 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. 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."
Game shows and investments
One experimental study with student-subject playing the game of the TV show Deal or No Deal
''Deal or No Deal'' is the name of several closely related television game shows, the first of which (launching the format) was the Dutch ''Miljoenenjacht (Netherlands), Miljoenenjacht'' (''Hunt/Chase for Millions''). The centerpiece of this f ...
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. In line with this, studies on investor behavior find that investors trade more and more speculatively after switching from phone-based to online trading and that investors tend to keep their core investments with traditional brokers and use a small fraction of their wealth to speculate online.
The behavioural approach to employment status
The basis of the theory, on the connection between employment status and risk aversion, is the varying income level of individuals. On average higher income earners are less risk averse than lower income earners. In terms of employment the greater the wealth of an individual the less risk adverse they can afford to be, and they are more inclined to make the move from a secure job to an entrepreneurial venture. The literature assumes a small increase in income or wealth initiates the transition from employment to entrepreneurship-based decreasing absolute risk aversion (DARA), constant absolute risk aversion (CARA), and increasing absolute risk aversion (IARA) preferences as properties in their utility function
As a topic of economics, 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 as part of the theory of utilitarianism by moral philosopher ...
. The apportioning risk perspective can also be used to as a factor in the transition of employment status, only if the strength of downside risk aversion exceeds the strength of risk aversion. If using the behavioural approach to model an individual’s decision on their employment status there must be more variables than risk aversion and any absolute risk aversion preferences.
Incentive effects are a factor in the behavioural approach an individual takes in deciding to move from a secure job to entrepreneurship. Non-financial incentives provided by an employer can change the decision to transition into entrepreneurship as the intangible benefits helps to strengthen how risk adverse an individual is relative to the strength of downside risk aversion. Utility functions do not equate for such effects and can often screw the estimated behavioural path that an individual takes towards their employment status.
The design of experiments, to determine at what increase of wealth or income would an individual change their employment status from a position of security to more risky ventures, must include flexible utility specifications with salient incentives integrated with risk preferences. The application of relevant experiments can avoid the generalisation of varying individual preferences through the use of this model and its specified utility functions.
See also
* Ambiguity aversion
In decision theory and economics, ambiguity aversion (also known as uncertainty aversion) is a preference for known risks over unknown risks. An ambiguity-averse individual would rather choose an alternative where the probability distribution of th ...
* Equity premium puzzle
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 obser ...
* Investor profile
An investor profile or style defines an individual's preferences in investment decisions, for example:
* Short-term trading (active management) or long term holding (buy and hold)
* Risk-averse or risk tolerant / seeker
* All classes of assets or ...
* Loss aversion
Loss aversion is the tendency to prefer avoiding losses to acquiring equivalent gains. The principle is prominent in the domain of economics. What distinguishes loss aversion from risk aversion is that the utility of a monetary payoff depends o ...
* Marginal utility
In economics, utility is the satisfaction or benefit derived by consuming a product. The marginal utility of a Goods (economics), good or Service (economics), service describes how much pleasure or satisfaction is gained by consumers as a result o ...
* Neuroeconomics
Neuroeconomics is an interdisciplinary field that seeks to explain human decision-making, the ability to process multiple alternatives and to follow through on a plan of action. It studies how economic behavior can shape our understanding of the ...
* Optimism bias
Optimism bias (or the optimistic bias) is a cognitive bias that causes someone to believe that they themselves are less likely to experience a negative event. It is also known as unrealistic optimism or comparative optimism.
Optimism bias is commo ...
* Problem gambling
Problem gambling or ludomania is repetitive gambling behavior despite harm and negative consequences. Problem gambling may be diagnosed as a mental disorder according to ''DSM-5'' if certain diagnostic criteria are met. Pathological gambling is ...
, a contrary behavior
* Prudence in economics and finance
* Risk premium
A risk premium is a measure of excess return that is required by an individual to compensate being subjected to an increased level of risk. It is used widely in finance and economics, the general definition being the expected risky return less t ...
* St. Petersburg paradox
The St. Petersburg paradox or St. Petersburg lottery is a paradox involving the game of flipping a coin where the expected payoff of the theoretical lottery game approaches infinity but nevertheless seems to be worth only a very small amount to t ...
* Statistical risk
Statistical risk is a Quantification (science), quantification of a situation's risk using statistical methods. These methods can be used to estimate a probability distribution for the outcome of a specific variable (statistics), variable, or at l ...
* Uncertainty avoidance
In cross-cultural psychology, uncertainty avoidance is how cultures differ on the amount of tolerance they have of unpredictability. Uncertainty avoidance is one of five key qualities or ''dimensions'' measured by the researchers who developed the ...
, which is different, as uncertainty is not the same as risk
* Utility
As a topic of economics, 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 as part of the theory of utilitarianism by moral philosopher ...
References
U.Sankar (1971), A Utility Function for Wealth for a Risk Averter, Journal of Economic Theory.
External links
*
*
*
Arrow-Pratt Measure on About.com:Economics
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The benefit of utilities: a plausible explanation for small risky parts in the portfolio
{{Authority control
Actuarial science
Behavioral finance
Financial risk modeling
Utility