Risk aversion under preference uncertainty

We show that if an agent is uncertain about the precise form of his utility function, his actual relative risk aversion may depend on wealth even if he knows his utility function lies in the class of constant relative risk aversion (CRRA) utility functions. We illustrate the consequences of this result for asset allocation: poor agents that are uncertain about their risk aversion parameter invest less in risky assets than wealthy investors with identical risk aversion uncertainty. Keywords: Risk Aversion , Preference Uncertainty , Risk-taking , Asset Allocation JEL Classification: D81, D84, G11 This Version: November 25, 201

The Nature of Risk Preferences: Evidence from Insurance Choices

We use data on households' deductible choices in auto and home insurance to estimate a structural model of risky choice that incorporates "standard" risk aversion (concave utility over final wealth), loss aversion, and nonlinear probability weighting. Our estimates indicate that nonlinear probability weighting plays the most important role in explaining the data. More specifically, we find that standard risk aversion is small, loss aversion is nonexistent, and nonlinear probability weighting is large. When we estimate restricted models, we find that nonlinear probability weighting alone can better explain the data than standard risk aversion alone, loss aversion alone, and standard risk aversion and loss aversion combined. Our main findings are robust to a variety of modeling assumptions.

Aversion Therapy

Excerpt: Aversion therapy uses a number of techniques and stimuli to weaken or eliminate undesirable responses such as deviant sexual behavior and substance abuse. In theory punishment is used to directly reduce the frequency of undesired behaviors through contingent presentation or removal of a stimulus, while aversion, or aversive counter-conditioning, seeks to change the undesirable response indirectly by altering the functions of the discriminative and reinforcing stimuli. In practice this distinction is somewhat blurred, since many aversion procedures have both punishing and stimulus-altering effects

Time Varying Risk Aversion: An Application to Energy Hedging

Risk aversion is a key element of utility maximizing hedge strategies; however, it has typically been assigned an arbitrary value in the literature. This paper instead applies a GARCH-in-Mean (GARCH-M) model to estimate a time-varying measure of risk aversion that is based on the observed risk preferences of energy hedging market participants. The resulting estimates are applied to derive explicit risk aversion based optimal hedge strategies for both short and long hedgers. Out-of-sample results are also presented based on a unique approach that allows us to forecast risk aversion, thereby estimating hedge strategies that address the potential future needs of energy hedgers. We find that the risk aversion based hedges differ significantly from simpler OLS hedges. When implemented in-sample, risk aversion hedges for short hedgers outperform the OLS hedge ratio in a utility based comparison

Individual-level loss aversion in riskless and risky choices

Loss aversion can occur in riskless and risky choices. Yet, there is no evidence whether people who are loss averse in riskless choices are also loss averse in risky choices. We measure individual-level loss aversion in riskless choices in an endowment effect experiment by eliciting both WTA and WTP from each of our 360 subjects (randomly selected customers of a car manufacturer). All subjects also participate in a simple lottery choice task which arguably measures loss aversion in risky choices. We find substantial heterogeneity in both measures of loss aversion. Loss aversion in the riskless choice task and loss aversion in the risky choice task are highly significantly and strongly positively correlated. We find that in both choice tasks loss aversion increases in age, income, and wealth, and decreases in education.Loss aversion, endowment effect, field experiments

An experimental test of loss aversion and scale compatibility

This paper studies two important reasons why people violate procedure invariance, loss aversion and scale compatibility. The paper extends previous research on loss aversion and scale compatibility by studying loss aversion and scale compatibility simultaneously, by looking at a new decision domain, medical decision analysis, and by examining the effect of loss aversion and scale compatibility on "well-contemplated preferences." We find significant evidence both of loss aversion and scale compatibility. However, the sizes of the biases due to loss aversion and scale compatibility vary over trade-offs and most participants do not behave consistently according to loss aversion or scale compatibility. In particular, the effect of loss aversion in medical trade-offs decreases with duration. These findings are encouraging for utility measurement and prescriptive decision analysis. There appear to exist decision contexts in which the effects of loss aversion and scale compatibility can be minimized and utilities can be measured that do not suffer from these distorting factors.Decision analysis, utility theory, loss aversion, scale compatibility, health

The role of risk aversion in non-conscious decision making

To what extent can people choose advantageously without knowing why they are making those choices? This hotly debated question has capitalized on the Iowa Gambling Task (IGT), in which people often learn to choose advantageously without appearing to know why. However, because the IGT is unconstrained in many respects, this finding remains debated and other interpretations are possible (e.g., risk aversion, ambiguity aversion, limits of working memory, or insensitivity to reward/punishment can explain the finding of the IGT). Here we devised an improved variant of the IGT in which the deck-payoff contingency switches after subjects repeatedly choose from a good deck, offering the statistical power of repeated within-subject measures based on learning the reward contingencies associated with each deck. We found that participants exhibited low confidence in their choices, as probed with post-decision wagering, despite high accuracy in selecting advantageous decks in the task, which is putative evidence for non-conscious decision making. However, such a behavioral dissociation could also be explained by risk aversion, a tendency to avoid risky decisions under uncertainty. By explicitly measuring risk aversion for each individual, we predicted subjects’ post-decision wagering using Bayesian modeling. We found that risk aversion indeed does play a role, but that it did not explain the entire effect. Moreover, independently measured risk aversion was uncorrelated with risk aversion exhibited during our version of the IGT, raising the possibility that the latter risk aversion may be non-conscious. Our findings support the idea that people can make optimal choices without being fully aware of the basis of their decision. We suggest that non-conscious decision making may be mediated by emotional feelings of risk that are based on mechanisms distinct from those that support cognitive assessment of risk

Inequity Aversion May Increase Inequity

Inequity aversion models have been used to explain equitable payoff divisions in bargaining games. I show that inequity aversion can actually increase the asymmetry of payoff division if unanimity is not required. This is due to the analogy between inequity aversion and risk aversion. Inequity aversion may also affect comparative statics: the advantage of being proposer can decrease as players become more impatient.Noncooperative Bargaining, Coalition Formation, Inequity Aversion

Comparative Ross Risk Aversion in the Presence of Mean Dependent Risks

This paper studies comparative risk aversion between risk averse agents in the presence of a background risk. Although the literature covers this question extensively, our contribution differs from most of the literature in two respects. First, background risk does not need to be additive or multiplicative. Second, the two risks are not necessary mean independent, and may be conditional expectation increasing or decreasing. We show that our order of cross Ross risk aversion is equivalent to the order of partial risk premium, while our index of decreasing cross Ross risk aversion is equivalent to decreasing partial risk premium. These results generalize the comparative risk aversion model developed by Ross (1981) for mean independent risks. Finally, we show that decreasing cross Ross risk aversion gives rise to the utility function family belonging to the class of n-switch utility functions.Comparative cross Ross risk aversion, Dependent background risk, Partial risk premium, Decreasing cross Ross risk aversion, n-switch utility function

Measuring Risk Aversion and the Wealth Effect

Measuring risk aversion is sensitive to assumptions about the wealth in subjects’ utility functions. Data from the same subjects in low- and high-stake lottery decisions allow estimating the wealth in a pre-specified one-parameter utility function simultaneously with risk aversion. This paper first shows how wealth estimates can be identified assuming constant relative risk aversion (CRRA). Using the data from a recent experiment by Holt and Laury (2002), it is shown that most subjects’ behavior is consistent with CRRA at some wealth level. However, for realistic wealth levels most subjects’ behavior implies a decreasing relative risk aversion. An alternative explanation is that subjects do not fully integrate their wealth with income from the experiment. Within-subject data do not allow discriminating between the two hypotheses. Using between-subject data, maximum-likelihood estimates of a hybrid utility function indicate that aggregate behavior can be described by expected utility from income rather than expected utility from final wealth and partial relative risk aversion is increasing in the scale of payoffs