Risk aversion

Risk aversion is a concept in psychology, economics, and finance, based on the behavior of humans (especially consumers and investors) while exposed to uncertainty.
Risk aversion is the reluctance of a person to accept a bargain with an uncertain payoff rather than another bargain with a more certain, but possibly lower, expected payoff. For example, a riskaverse investor might choose to put his or her 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.
Outside the rather mathematical fields of economics and finance, people have to make choices about how they face risks every day. Some have become very cautious, preferring to minimize risks even when the potential benefit of an action is large.
Contents
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:
 riskaverse (or riskavoiding)  if he or she would accept a certain payment (certainty equivalent) of less than $50 (for example, $40), rather than taking the gamble and possibly receiving nothing.
 riskneutral  if he or she is indifferent between the bet and a certain $50 payment.
 riskloving (or riskseeking)  if the guaranteed payment must be more than $50 (for example, $60) to induce him or her to take the guaranteed option, rather than taking the gamble and possibly winning $100.
The average payoff of the gamble, known as its expected value, is $50. The dollar amount that the individual would accept instead of the bet is called the certainty equivalent, and the difference between the expected value and the certainty equivalent is called the risk premium. For riskaverse individuals, it becomes positive, for riskneutral persons it is zero, and for riskloving individuals their risk premium becomes negative.
Utility of money
In expected utility theory, an agent has a utility function u(x) where x represents the value that he might receive in money or goods (in the above example x could be 0 or 100).
Time does not come into this calculation, so inflation does not appear. (The utility function u(x) is defined only up to affine transformation  in other words a constant factor could be added to the value of u(x) for all x, and/or u(x) 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,
 E(u) = (u(0) + u(100)) / 2,
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 4.0001 and u(50) might be 5.0001.
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 firstorder 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 meanpreserving 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).
The above is an introduction to the mathematics of risk aversion. However it assumes that the individual concerned will act entirely rationally and will not factor into his decision nonmonetary, psychological considerations such as regret at having made the wrong decision. Often an individual may come to a different decision depending on how the proposition is presented, even though there may be no mathematical difference.
Measures of risk aversion
Absolute risk aversion
The higher the curvature of u(c), 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. One such measure is the ArrowPratt measure of absolute riskaversion (ARA), after the economists Kenneth Arrow and John W. Pratt,^{[1]}^{[2]} also known as the coefficient of absolute risk aversion, defined as
 .
The following expressions relate to this term:
 Exponential utility of the form u(c) = 1 − e ^{− αc} is unique in exhibiting constant absolute risk aversion (CARA): A(c) = α is constant with respect to c.
 Hyperbolic absolute risk aversion (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, 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 R = 1 / a and c_{s} = − b / a. Note that when a = 0, this is CARA, as A(c) = 1 / b = const, and when b = 0, this is CRRA (see below), as cA(c) = 1 / a = const. See ^{[3]}
 Decreasing/increasing absolute risk aversion (DARA/IARA) is present if A(c) is decreasing/increasing. Using the above definition of ARA, the following inequality holds for DARA:
and this can hold only if u'''(c) > 0. Therefore, DARA implies that the utility function is positively skewed; that is, u'''(c) > 0^{[4]}. Analogously, IARA can be derived with the opposite directions of inequalities, which permits but does not require a negatively skewed utility function (u'''(c) < 0). An example of a DARA utility function is u(c) = log(c), with A(c) = 1 / c, while u(c) = c − αc^{2}, α > 0, with A(c) = 2α / (1 − 2αc) would represent a quadratic utility function exhibiting IARA.
 Experimental and empirical evidence is mostly consistent with decreasing absolute risk aversion.^{[5]}
 Contrary to what several empirical studies have assumed, wealth is not a good proxy for risk aversion when studying risk sharing in a principalagent 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.^{[6]}
Relative risk aversion
The ArrowPratt measure of relative riskaversion (RRA) or coefficient of relative risk aversion is defined as
 .
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 riskaverse to riskloving 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, the expected utility function u(c) = log(c) implies RRA = 1.
In intertemporal choice problems, the elasticity of intertemporal substitution is often unable to be disentangled from the coefficient of relative risk aversion. The isoelastic utility function
exhibits constant relative risk aversion with R(c) = ρ and the elasticity of intertemporal substitution ε_{u(c)} = 1 / ρ. When ρ = 1 and one is subtracted in the numerator (facilitating the use of l'Hôpital's rule), this simplifies to the case of log utility, and the income effect and substitution effect on saving exactly offset.
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 riskfree asset.^{[1]}^{[2]} 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).
Portfolio theory
In modern portfolio theory, risk aversion is measured as the additional marginal reward an investor requires to accept additional risk. In modern portfolio theory, risk is being measured as 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 being measured as the nth radical of the nth central moment. The symbol used for risk aversion is A or A_{n}.
Limitations
The notion of (constant) risk aversion has come under criticism from behavioral economics. According to Matthew Rabin of UC Berkeley, a consumer who,
from any initial wealth level [...] turns down gambles where he loses $100 or gains $110, each with 50% probability [...] will turn down 5050 bets of losing $1,000 or gaining any sum of money.
It is noteworthy that Rabin's article went on to criticize the whole field of expected utility and not just constant relative risk aversion. This has led to some confusion in the field. 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 to consider only the final wealth.
Risk aversion in the brain
Attitudes towards risk have attracted the interest of the field of neuroeconomics. A study by researchers at the University of Cambridge ^{[7]} 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,^{[8]}^{[9]} 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 riskaverse 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. David Spiegelhalter is the Winton Professor of the Public Understanding of Risk at Cambridge University; a role he describes as "outreach".^{[10]}
Children's services such as schools and playgrounds have become the focus of much riskaverse planning, meaning that children are often prevented from benefiting from activities that they would otherwise have had. Many playgrounds have been fitted with impactabsorbing 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.^{[11]} 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), andsome arguechildren 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."^{[12]} There are also classroom courses in risk taking, for example from a business perspective.^{[13]}
A vaccine to protect children against the three common diseases measles, mumps and rubella was developed and recommended for all children in several countries including the UK. However, a controversy arose around allegations that it caused autism. This alleged causal link was thoroughly disproved,^{[14]} and the doctor who made the claims was expelled from the General Medical Council. Even years after the claims were disproved, some parents wanted to avert the risk of causing autism in their own children. They chose to spend significant amounts of their own money on alternatives from private doctors. These alternatives carried their own risks which were not balanced fairly; most often that the children were not properly immunised against the more common diseases of measles, mumps and rubella.
Similarly, mobile phones may carry some small^{[15]}^{[16]} health risk. While most people would accept that unproven risk to gain the benefit of improved communication, others remain so risk averse that they do not. The COSMOS cohort study continues to study the actual risks of mobile phones.
Risk aversion theory can be applied to many aspects of life and its challenges, for example:
 Bribery and corruption  whether the risk of being implicated or caught outweighs the potential personal or professional rewards
 Drugs  whether the risk of having a bad trip outweighs the benefits of possible transformative one; whether the risk of defying social bans is worth the experience of alteration. See "Harm Reduction".
 Sex  judgement whether an experience that goes against social convention, ethical mores or common health prescriptions is worth the risk.
 Extreme sports  having the ability to go against biological predepositions like the fear of height.
 Play by children in playgrounds or beyond the reach of their parents.
See also
 Ambiguity aversion
 Optimism bias
 Utility
 Risk premium
 Equity premium puzzle
 Investor profile
 Loss aversion
 St. Petersburg paradox
 Compulsive gambling, a contrary behavior
 Neuroeconomics
 Prudence in economics and finance
 Diminishing marginal utility
External links
 Paper about problems with risk aversion
 Economist article on monkey experiments showing behaviours resembling risk aversion (requires a paid subscription to economist.com)
 ArrowPratt Measure on About.com:Economics
 Risk Aversion of Individuals vs Risk Aversion of the Whole Economy
 The benefit of utilities: a plausible explanation for small risky parts in the portfolio
References
 ^ ^{a} ^{b} Arrow, K.J.,1965, "The theory of risk aversion," in Aspects of the Theory of Risk Bearing, by Yrjo Jahnssonin Saatio, Helsinki. Reprinted in: Essays in the Theory of Risk Bearing, Markham Publ. Co., Chicago, 1971, 90–109.
 ^ ^{a} ^{b} Pratt, J. W., "Risk aversion in the small and in the large," Econometrica 32, January–April 1964, 122–136.
 ^ Zender's lecture notes
 ^ Haim Levy (2006), Stochastic Dominance: Investment Decision Making under Uncertainty, Springer
 ^ Friend, Irwin and Blume, Marshall (1975), The Demand for Risky Assets, The American Economic Review.
 ^ Bellemare, Marc F. and Zachary S. Brown, On the (Mis)Use of Wealth as a Proxy for Risk Aversion[1], Working Paper, Duke University.
 ^ Christopoulos GI; Tobler PN; Bossaerts P; Dolan RJ; Schultz W (2009). "Neural Correlates of Value, Risk, and Risk Aversion Contributing to Decision Making under Risk.". J Neurosci 26 (24): 6469–6472. doi:10.1523/JNEUROSCI.080406.2006. PMID 16775134.
 ^ Knoch D, Gianotti LR, PascualLeone A, Treyer V, Regard M, Hohmann M, Brugger P (2006). "Disruption of right prefrontal cortex by lowfrequency repetitive transcranial magnetic stimulation induces risktaking behavior.". J Neurosci 26 (24): 6469–6472. doi:10.1523/JNEUROSCI.080406.2006. PMID 16775134.
 ^ Fecteau S, PascualLeone A, Zald DH, Liguori P, Théoret H, Boggio PS, Fregni F (2007). "Activation of prefrontal cortex by transcranial direct current stimulation reduces appetite for risk during ambiguous decision making.". J Neurosci 27 (23): 6212–6218. doi:10.1523/JNEUROSCI.031407.2007. PMID 17553993.
 ^ Spiegelhalter, David (Michaelmas 2009). "Don's Diary". CAM. 58. Cambridge University Alumni Association. p. 3. http://www.alumni.cam.ac.uk/uploads/File/CAM58/CAM58.pdf#page=5.
 ^ Gill, Tim (2007). No fear: Growing up in a Risk Averse society. Calouste Gulbenkian Foundation. p. 81. ISBN 9781903080085. http://www.gulbenkian.org.uk/media/item/1266/223/Nofear19.12.07.pdf#page=28.
 ^ Sue Durant, Sheila Sage (10 January 2006). Early Years  The Outdoor Environment. Teachers TV. http://www.teachers.tv/video/214.
 ^ Wetton, Noreen; Wilson, John (February 2007). Confident to Earn. Scottish Executive Education Department. http://www.ea.erenfrew.sch.uk/curriculinks/Links/Teachers/ConfidentToEarn.pdf
 ^ Madsen KM, Hviid A, Vestergaard M et al. (2002). "A populationbased study of measles, mumps, and rubella vaccination and autism". N Engl J Med 347 (19): 1477–82. doi:10.1056/NEJMoa021134. PMID 12421889.
 ^ "What are the health risks associated with mobile phones and their base stations?". Online Q&A. World Health Organization. 20051205. http://www.who.int/features/qa/30/en. Retrieved 20080119.
 ^ "Electromagnetic fields and public health: mobile telephones and their base stations". Fact sheet N°193. World Health Organization. June 2000. http://www.who.int/mediacentre/factsheets/fs193/en. Retrieved 20080119.
Categories: Actuarial science
 Behavioral finance
 Economics of uncertainty
 Risk
 Financial risk
 Utility
Wikimedia Foundation. 2010.
Look at other dictionaries:
risk aversion — Attitudes toward *risk characterized by avoidance or minimization. Risk averse investors are deemed to have low *risk appetites they prefer certain but relatively low rates of *return over doubtful but higher rates of return. For example, an… … Auditor's dictionary
Risk aversion coefficient — коэффициент неприятия риска. См. также: Инвестиционные риски Финансовый словарь Финам … Финансовый словарь
Risk — takers redirects here. For the Canadian television program, see Risk Takers. For other uses, see Risk (disambiguation). Risk is the potential that a chosen action or activity (including the choice of inaction) will lead to a loss (an undesirable… … Wikipedia
Risk premium — A risk premium is the minimum amount of money by which the expected return on a risky asset must exceed the known return on a risk free asset, in order to induce an individual to hold the risky asset rather than the risk free asset. Thus it is… … Wikipedia
risk — risker, n. riskless, adj. /risk/, n. 1. exposure to the chance of injury or loss; a hazard or dangerous chance: It s not worth the risk. 2. Insurance. a. the hazard or chance of loss. b. the degree of probability of such loss. c. the amount that… … Universalium
Risk neutral — In economics, risk neutral behavior is in between risk aversion and risk seeking. If offered either 50 EUR or a 50% chance of 100 EUR, a risk averse person will take the 50 EUR, a risk seeking person will take the 50% chance of 100 EUR, and a… … Wikipedia
Risk Lover — An investor who is willing to take on additional risk for an investment that has a relatively low expected return. This contrasts with the typical investor mentality risk aversion. Risk averse investors tend to take on increased risks only if… … Investment dictionary
risk — {{11}}risk (n.) 1660s, risque, from Fr. risque, from It. risco, riscio (modern rischio), from riscare run into danger, of uncertain origin. The anglicized spelling first recorded 1728. Sp. riesgo and Ger. Risiko are Italian loan words. Risk… … Etymology dictionary
risk transfer — The shifting of risk through insurance or securitization of debt because of risk aversion . Bloomberg Financial Dictionary … Financial and business terms
Aversion a la perte — Aversion à la perte L aversion à la perte sur un marché financier est la réticence relativement répandue chez les investisseurs, notamment néophytes, à se séparer d un actif qui vaut moins sur le marché que le prix où le détenteur l avait acheté … Wikipédia en Français