Risk aversion
In economics and finance, risk aversion is the behavior of humans, who, when exposed to uncertainty, attempt to lower that uncertainty. It is the hesitation of a person to agree to a situation with an unknown payoff rather than another situation with a more predictable payoff but possibly lower expected 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.
Example
A person is given the choice between two scenarios, one with a guaranteed payoff and one without. In the guaranteed 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 - if they would accept a certain payment of less than $50, rather than taking the gamble and possibly receiving nothing.
- risk neutral – if they are indifferent between the bet and a certain $50 payment.
- risk loving – if they would accept the bet even when the guaranteed payment is more than $50.
Utility of money
In expected utility theory, an agent has a utility function u where c represents the value that he might receive in money or goods.The utility function u is defined only up to positive affine transformation – in other words, a constant could be added to the value of u for all c, and/or u 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 could be 0, u might be 10, u might be 5, and for comparison u might be 6.
The expected utility of the above bet is
and if the person has the utility function with u=0, u=5, and u=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 =$10, or in proportional terms
or 25%. 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 and u = 10, then u might be 4.0001 and u might be 5.0001.
The utility function for perceived gains has two key properties: an upward slope, and concavity. 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. 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.
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, a measure that stays constant with respect to these transformations is needed. One such measure is the Arrow–Pratt measure of absolute risk aversion, after the economists Kenneth Arrow and John W. Pratt, also known as the coefficient of absolute risk aversion, defined aswhere and denote the first and second derivatives with respect to of.
The following expressions relate to this term:
- Exponential utility of the form is unique in exhibiting constant absolute risk aversion : is constant with respect to c.
- Hyperbolic absolute risk aversion is the most general class of utility functions that are usually used in practice, CARA. A utility function exhibits HARA if its absolute risk aversion is a hyperbolic function, namely
where and.
Note that when, this is CARA, as, and when, this is CRRA, as.
See
- Decreasing/increasing absolute risk aversion is present if is decreasing/increasing. Using the above definition of ARA, the following inequality holds for DARA:
- 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
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 and decreasing/increasing relative risk aversion 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 = log c, and the income effect and substitution effect 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 the number of dollars of the risky asset held in the portfolio if absolute risk aversion is decreasing. 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 the fraction of the portfolio held in the risky asset if relative risk aversion is decreasing.
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.
Portfolio theory
In modern portfolio theory, risk aversion is measured as the additional expected reward an investor requires to accept additional risk. 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 A_{n}.Limitations of expected utility treatment of risk aversion
The notion of using expected utility theory's approach to risk aversion to analyze small stakes decisions has come under criticism from behavioral economics. 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.
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, rather than to consider 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 prospects as opposed to positive prospects. According to this effect, people tend to avoid risks under the gain domain, and to seek risks under the loss domain. Meaning, no risk aversion is expected under the loss domain. For example, in the gain domain, most people prefer a certain gain of 3000, than a gain of 4000 with a risk of 80 percent. When posing the same problem under the loss domain - with negative values, most people prefer a loss of 4000 with 80 percent chance, over a certain loss of 3000.
The reflection 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. Meaning, options which are perceived as certain, are over-weighted relative to uncertain options. This pattern is an indication of a 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 and behavioral economics. A 2009 study by Christopoulos et al. suggested that the activity of a specific brain area correlates with risk aversion, with more risk averse participants also having higher responses to safer options. This result coincides with other studies, 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 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.