Underatanding Risk & Attitudes towards Risk together with a Comparative Perspective between Expected Utility Maximization &

Prospect Theories
MIB Session 1: Dec 27, 2012 Prof. Samar K. Datta

Sub-topics to be discussed
Two ways to model risk

Preferences toward risk

Mechanisms for reducing risk Where does Prospect Theory differ?

Standard deviation measuring risk

Deviations or differences between expected payoff and actual payoff are important The standard deviation measures the square root of the average of the squares of the deviations of the payoffs associated with each outcome from their expected value.

Why SD important?
f(X), g(Y) = prob. densities
Which distribution would you prefer, if you are risk-averse?

While the expected values are the same, the variability is not. Greater variability from expected values signals greater risk. X, Y E(X)=E(Y), but sd(X) >sd(Y)

Approaches to model risk-averseness

Assumptions for choosing among risky alternatives Consumption of a single commodity The consumer knows all probabilities Payoffs measured in terms of utility Utility function given

Approach 1: Max U [E(income), SD(income)]

(+)
Approach 2: Max E[U(income)]

(-)

Risk Averse Prefernces Toward Risk

Utility

E
D C B A

18
16 14 13

The consumer is risk averse because she would prefer a certain income of $20,000 to a gamble with a 0.5 probability of $10,000 and a 0.5 probability of $30,000.

10

Risk averseness means gain valued less than loss at the margin

10

15 16 20

30

Income ($1,000)

Risk Neutral Preferences Toward Risk

E

Utility

18

A person is said to be risk neutral if he shows no preference between a certain income, and an uncertain one with the same expected value.

12

The consumer is risk neutral as he is indifferent between certain events and uncertain events with the same expected income.

Risk neutrality means gain valued same as loss at the margin

10

20

30

Income ($1,000)

Risk Loving Preferences

Utility 18
From rapid growth of casinos almost everywhere, is it proper to argue that most countries are becoming nations of gamblers?

A person is said to be risk loving if he shows a preference toward an uncertain income over a certain income with the same expected value. Examples: gambling, criminal activity

E
The consumer is risk loving because she would prefer the gamble to a certain income.

8 A 3 0 10

Risk loving behavior mean gain valued more than loss at the margin

20

30

Income ($1,000)

Notion of Risk Premium

The risk premium is the amount of money that a risk-averse person would pay to avoid taking a risk.

R = U[E(Y)] E[U(Y)] in utility terms

It can also be measured along the horizontal axis in terms of money
The greater the variability i.e., the spread of values of

the random variable around mean, the greater the risk premium.

The greater the concavity of the utility curve, the greater

the risk premium it means a much higher weight is assigned to a decline in income as compared to an equal amount of rise in income

Estimating Risk Premium

Utility Risk Premium in money terms G
20 18 14
Here , the risk premium is $4,000 because a certain income of $16,000 gives the person the same expected utility as the uncertain income that has an expected value of $20,000. Risk premium in utility terms

C
A F

10

10

16

20

30

40

Income ($1,000)

Meaning of High Degree of Risk Aversion

U3
Expected Income

U2 U1

Here increase in Standard deviation requires a large increase in income to maintain satisfaction.

Standard Deviation of Income

Meaning of Low Degree of Risk Aversion

Expected Income Slightly Risk Averse => A large increase in standard deviation requires only a small increase in income to maintain satisfaction.

U3
U2 U1

Standard Deviation of Income

Indifference curves of riskneutral & risk-loving people

Risk-neutrality means horizontal indifference curve showing zero premium the consumer is willing to pay to buy hedge against risk (i.e., he doesnt mind bearing more risk) Risk-lover willing to pay (i.e., make sacrifice in terms expected income) to enjoy the thrill of greater risk-bearing thus making indifference curves usual downward sloping

Utility function of a person who buys insurance and gambles too!

Total utility
TU curve

Concave to horizontal axis

Convex to horizontal axis A

Near point of inflection, A (MU at its minimum), a rise averter will spend small amount to buy insurance against small chance of large loss, while as a risk seeker spend a small amount (on lottery) to seize small chance of a large gain.

Income

Risk Reduction Strategies

Three ways consumers attempt to reduce risk are: 1) Diversification 2) Insurance 3) Obtaining more information Firms can reduce risk by diversifying among a variety of activities that are not closely related.

Reducing Risk Insurance

Risk averse are willing to pay to avoid risk If the cost of insurance equals the expected loss, risk averse people will buy enough insurance to recover fully from a potential financial loss For the risk averse consumer, guarantee of same income regardless of outcome has higher utility than facing the probability of risk Expected utility with insurance is higher than without Purchases of insurance transfers wealth and increases expected utility

Actuarial Fairness: When the insurance premium = expected payout

Important Issues on Insurance

Formal insurance always needed or available to hedge against any risk? Will supplier of insurance be necessarily a risk-lover? What about buyer of insurance? Is provision of insurance always possible? Does supplier of insurance also need insurance?

Arrow-Pratt Risk-aversion Measures

Absolute risk-aversion, A(y) =
-d[u(y)]/d[u(y)] = - U(y)/U(y)

Relative risk-aversion, R(y) =

Elasticity of U(y) w.r.t. y = -d[log U(y)]/d[logy] = -[U(y)/U(y)]/[dy/y] =-[U(y).y]/U(y)

Some commonly used utility functions

1. U = 1 e-ay, a>0; A(y)=a, R(y)=ay 2. U = ay by2, a,b>0 for 0ya/2b; A(y)=2b/(a-2by), R(y)=2by/(a-2by) 3. U=[1-y(1-a)]/(a-1), a0; A(y)=a/y, R(y)=a

A counter-perspective of Prospect Theory

The classical models of rationality specifies how people should make decision in the face of risk. Extensive experimentation, however, reveal that departures from that model occur more frequently than most of us admit. Evidence suggests that we reach decisions in accord with an underlying structure that enables us to function predictably and, in most instances, systematically. The issue, rather, is the degree to which the reality in which we make our decisions deviates from the rational decision models

Kahneman and Tversky: Differences mainly due to two human shortcomings

.First, emotion often destroys the self-control that is essential to rational decision-making. Second, people are often unable to understand fully what they are dealing with. They experience what psychologists call cognitive difficulties. Also difficulty in sampling, as we have a hard time drawing valid generalizations from what we observe. Result: We pay excessive attention to lowprobability events accompanied by high drama and overlook events that happen in routine fashion.

Example: how initial perceptions mislead us

Ask yourself whether the letter K appears more often as the first or as the third letter of English words. You will probably answer that it appears more often as the first letter. Actually, K appears as the third letter twice as often. Why the error? We find it easier to recall words with a certain letter at the beginning than words with that same letter somewhere else.

Findings of Prospect Theory

Asymmetry between the way we make decisions involving gains and decisions involving losses is one of the most striking findings of Prospect Theory. The major driving force is loss aversion, writes Tversky (italics added). It is not so much that people hate uncertainty but rather, they hate losing. Losses will always loom larger than gains. People are much more sensitive to negative than to positive stimuli. There are few things that would make us feel better, but the number of things that would make us feel worse is unbounded.

Example of Loss-aversion
A rare disease breaking out in some community expected to kill 600 people. Two programs available to handle the threat: Program A: 200 people will be saved; Program B: 33% probability that everyone will be saved and 67% probability that no one will be saved. Rational risk-averse people will prefer Plan As certainty of saving 200 lives over Plan Bs gamble, which has the same mathematical expectancy but involves taking the risk of a 67% chance that everyone will die. In the experiment, 72% of the subjects chose the risk-averse response represented by Program A.

Identical problem posed differently

Program C: 400 of the 600 will die, Program D: 33% probability that nobody will die and 67% probability that 600 people will die. Note first of the two choices expressed in terms of 400 deaths rather than 200 survivors, while the second program offers a 33% chances that no one will die. Kahneman and Tversky report that 78% of their subjects were risk-seekers and opted for the gamble: they could not tolerate the prospect of the sure loss of 400 lives.

Further findings
Invariance is normatively essential (what we should do), intuitively compelling, but psychologically unfeasible. The manner in which questions are framed in advertising may persuade people to buy something despite negative consequences that, in a different frame, might persuade them to refrain from buying. Advertisement may thus change the perspective of a buyer.

An Example
Medical data in hospital showed that no patients die during radiation but have shorter life expectancy than patients who survive the risk of surgery; the overall difference in life expectancy was not great enough to provide a clear choice between the two forms of treatment. When the question was put in terms of risk of death during treatment, more than 40% of the choices favored radiation. When the question was put in terms of life expectancy, only about 20% favored radiation.

Findings of the theory of Mental Accounting

Loss is less painful when it is just an addition to a larger loss than when it is a free-standing loss. Example: when moving into a new home, Kahneman and his wife bought all their furniture within a week after buying the house. If they had looked at the furniture as a separate account, they might have balked at the cost and ended up buying fewer pieces than they needed.

Role of Information & Ambiguity Aversion

Information is a necessary ingredient to rational decision-making and more information offer opportunities for people in authority to manipulate the kinds of risk that people are willing to take. Ambiguity Aversion means that people prefer to take risks on the basis of known rather than unknown probabilities.

Example and implications of Ambiguity Aversion

Example: Ellsberg offered several groups of people a chance to bet on drawing either a red ball or a black ball from two different urns, each holding 100 balls. Urn 1 hold 50 balls of each color; the breakdown in Urn 2 was unknown. Probability theory would suggest that Urn 2 was also split 50-50, as there was no basis for any other distribution. Yet the overwhelming preponderance of the respondents close to bet on the draw from Urn 1. Ambiguity aversion is driven by the feeling of incompetence and will be present when subjects evaluate clear and vague prospects jointly, but it will greatly diminish or disappear, when they evaluate each prospect in isolation.

Final Implications for Theories of Choice

Evidence indicates that human choices are orderly, although not always rational in the traditional sense of the word.

Since orderly decisions are predictable, there is no basis for the argument that behavior is going to be random and erratic merely because it fails to provide a perfect match with rigid theoretical assumption.

Conclusion
The science of risk management sometimes creates new risks even as it brings old risks under control. Example: Seatbelts encourage drivers to drive more aggressively. Consequently, the number of accidents rises even though the seriousness of injury in any one accident declines. Many catastrophic errors of judgment are thus either avoided, or else their consequences are muted. Hence there is a transformation in the perception of risk from chance of loss into opportunity for gain, from FATE and ORIGINAL DESIGN to sophisticated, probability-based forecasts of the future, and from helplessness to choice.