Economics
Risk Preference
Risk preference refers to an individual's willingness to take on risk in exchange for potential rewards. It is a key concept in decision-making under uncertainty, as it influences choices related to investments, insurance, and other financial decisions. Risk preference can vary among individuals, with some being risk-averse, seeking to minimize risk, while others are risk-seeking, willing to take on higher levels of risk for potentially greater returns.
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5 Key excerpts on "Risk Preference"
eBook - PDF- Dana L. Hoag(Author)
- 2009(Publication Date)
- CRC Press(Publisher)
This is also known as risk tolerance . Risk Preference scores help define what constitutes acceptable versus unacceptable levels of risk. While Risk Preference is beneficial for investors to understand, the formulas are rather complex. In this section, we review the theory and formulas used to create the algorithms used in Part 3, Risk Navigator SRM tools. Corn Crop Revenue Normal U.S. crop Short U.S. crop P = 0.50 P = 0.50 $350,000 $250,000 Sell later Sell at harvest $275,000 FIGURE 6.1 A decision tree for holding or selling corn crops. Step 2: Determine Risk Preferences 95 An individual’s Risk Preference depends upon his wealth, how much satisfaction he derives from his wealth, and the rate of satisfaction he derives from increases in wealth. This can be measured by utility (U), a scale of satisfaction. The amount of utility a person receives from wealth (W) is written as U(W). A utility function, shown in Figure 6.2, maps utility (the dependent variable) as a function of wealth. In this case, utility is scaled from 0 to 100, where 0 reflects no satisfaction and 100 is maximum satisfaction. The curve is bowed outward (concave) because each addi-tional unit of (W) adds less satisfaction than the previous unit. When wealth is small, an additional dollar can provide a lot of satisfaction. But as you grow wealthier, the last dollar received doesn’t provide nearly as much satisfaction as that first dollar. Think about sitting down to eat a bag of popcorn. The first bite gives you more sat-isfaction than the last. Risk attitudes are determined by the shape of the utility function shown in Figure 6.2, which reflects how quickly satisfaction diminishes with additional wealth. The slope for risk-averse, risk-neutral, and risk-seeking individuals is positive. This is intuitive because more wealth or profit is preferred to less.
eBook - PDF- Martin F. Kaplan(Author)
- 2013(Publication Date)
- Academic Press(Publisher)
Any inter-pretation of the theory for experimental purposes would, of course, require an operational or empirical definition of risk. But it is important to recognize that theory about risk itself is independent of a theory of preference for risk; one can build and test a theory of risk independently of a theory of Risk Preference (see, for example, Pollatsek & Tversky, 1970). The purpose of portfolio theory is to provide a basis for making inferences about the riskiness of gambles from pref-erential choices. The theory is eminently testable and leads to the study of risk with no a priori assumptions or semantic confusion about its nature intruding into an experiment. The first assumption of the theory asserts that what is left to mediate preference after expectation is held constant is a risk-preference function. The second assumption says that this function is single peaked over the risk ordering. The property of single peakedness means in this instance that in any triple of gambles with the same expected value and ordered in risk, the intermediate one cannot be the least preferred. The psychological idea here is that for a fixed expectation an individual has an optimum level of risk and that his preference falls off as risk increases or decreases. The plausibility of such an assumption can be enhanced if we consider the following. To increase the riskiness of a gamble must surely require increasing the amount to be lost and/or increasing the probability of losing. To increase the risk of a gamble, then, and at the same time preserve the expected value requires compensatory changes in the amount to be won and/or the probability of winning.
eBook - PDF- P. Molyneux(Author)
- 2011(Publication Date)
- Palgrave Macmillan(Publisher)
157 8.1 Introduction This paper focuses on risk tolerance, which works as a relevant feature affecting financial decision-making. Specifically, financial risk tolerance may be defined as ‘the maximum amount of uncertainty someone is willing to accept when making a financial decision’ (Grable, 2008). Theoretically, financial risk tolerance depends upon different dimen- sions of risk. Weber et al. (2002) refer to risk attitude as ‘a person’s stand- ing on the continuum from risk aversion to risk seeking’ (p. 222), and they contend that the degree of risk-taking is highly domain-specific. Risk-averse individuals in one domain (e.g., financial choices) may not behave consistently across other domains (sports, social skills...). In a word, risk taking behaviour is multidimensional. From the perspective of financial planners (Cordell, 2002; Boone and Lubitz, 2003), financial risk tolerance can be defined as a combination of both ‘risk attitude’ (how much risk I choose to take) and ‘risk capacity’ (how much risk I can afford to take). Nevertheless, these two components of risk tolerance are intrinsically different: risk attitude is a psychological attribute (Weber et al., 2002, also refer to it as a personality trait), whereas risk capacity is principally a financial attribute. Many scholars from different disciplines have analysed how risk, risk perception and risk tolerance influence individuals when making choices under uncertainty. The notion of risk in the decision process is an essen- tial element within the classical economic theoretical background (the so-called normative approach), from the Expected Utility theory of Von Neumann and Morgenstern (1944) to the Modern Portfolio Theory of Markowitz (1952). However, in stark contrast, the early works of behav- ioural economics in the 1970s, from the prospect theory of Kahneman 8 Errors in Individual Risk Tolerance Caterina Lucarelli and Gianni Brighetti
eBook - PDFMarkets, Games, and Strategic Behavior
An Introduction to Experimental Economics (Second Edition)
- Charles A. Holt, Charles Holt(Authors)
- 2019(Publication Date)
- Princeton University Press(Publisher)
In any case, it is important to keep the diminishing- marginal-utility intuition for risk aversion in mind, since this factor plays such a prominent role in investments, insurance, and other types of economic decisions. There is a large literature on Risk Preferences, and many issues have been passed over here, e.g., whether utility should be a function of final wealth or of income (gains or losses from current wealth). In this chapter, we treat the util-ity as a function of income (gains and losses) instead of final wealth. There is experimental and theoretical evidence for this (Rabin, 2000; Cox and Vjollca, 2001). Appropriate reference points that separate gains from losses will be dis-cussed in the next chapter. In a provocative book entitled Risky Curves: On the Empirical Failure of Expected Utility Theory , Friedman et al. (2014) argue that different measures of risk aver-sion are not strongly correlated and are not very predictive of behavior in risky situations. The reader may also wish to peruse Eckel’s (2016) thoughtful and nu-anced review of this book. Friedman et al. note that risk of low or negative payoffs is considered to be much more serious than risk associated with high payoffs, a topic that will be revisited in the context of “upside” and “downside” risk in the next chapter. Deck et al. (2013) did find a significant ( p = 0.01) within-subjects Risk and Decision Making 57 correlation between Holt-Laury (tabular) and Eckel-Grossman (investment task) measures of risk aversion, with a correlation of 0.27, although there is no corre-lation between either of those measures and two more dynamic (“balloon” and “deal-or-no-deal”) tasks. One takeaway is that Risk Preferences may be multi-dimensional in a way that existing measurement tasks do not pick up. Sometimes one gets the impression that other emotions can dominate Risk Preferences, e.g., the urge to speculate during an asset price surge may dimin-ish natural caution.
- Mark Machina, W. Kip Viscusi(Authors)
- 2013(Publication Date)
- North Holland(Publisher)
While they used voting to arrive at a group decision, the group choice was based on a single majority vote of anonymous three-person groups. 31 All sessions were conducted in Colombia, and 70 percent of the subjects were male. Subjects were cash-motivated, but each subject had a 10 percent probability of being paid their experi-ment earnings. They found no significant difference between group and individual choices.They do not report any test of interactions between the probability of the better outcome and the difference between group and individual choices, so it is not clear whether this finding from other studies is present in their data. 4.4.3 Stability of Risk Preferences Across Domains Most experiments measure the Risk Preference of a subject at a single point in time and in a single context. In some cases (including many of those cited in this chapter), what interests the researcher is simply a measure of risk aversion or individual characteristics that affect the degree of risk aversion. However, in other situations risk aversion is elic-ited to predict or explain behavior in another (often related) environment. For example, Andersen et al. (2008) demonstrate that one obtains biased estimates of discount rates if the curvature of the utility function is ignored. They propose a two-stage approach to measure discount rates. They elicit choices in a Holt-Laury Risk Preference experiment, and also choices in a standard discount rate elicitation task. 32 They obtain a curvature-adjusted discount rate estimate using a dual estimation procedure in which they use the risk-preference choices to measure the curvature of the utility function and then use the discount rate choices to estimate a curvature-adjusted discount rate.
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