Probabilistic risk attitudes and local risk aversion: a paradox (original) (raw)
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Risk Aversion as Attitude towards Probabilities: A Paradox
Theories of decision under risk that challenge expected utility theory model risk attitudes at least partly with transformation of probabilities. We explain how attributing risk aversion (partly or wholly) to attitude towards probabilities, can produce extreme probability distortions that imply paradoxical risk aversion.
The Role of Risk Attitudes in Probabilistic Environments
2013
In this work we asked if risk attitudes influence the way agents learn in a probabilistic environment. For that purpose, 31 male students played a version of a well-known game called the multi-armed bandit (with four levers/buttons). We found that after controlling for cognitive abilities (i.e. Raven’s test), risk seekers in gains preferred to explore in this environment, rather than exploit options, even if one of them was clearly more rewarding. We briefly discuss the reasons and some implications for financial decision theories, in particular, for Bayesian and behavioral proposals.
Risk aversion making economic decisions, certainty effect and probabilities estimation
it has been empirically observed that the principles of utility theory are frequently violated when making decisions in risky environments. This led to the formulation of the prospect theory, in which, besides taking into account the different consideration of gains and losses (losses loom larger than gains) as well as the risk posture of decision-makers (risk aversion for gains and risk seeking for losses), the certainty effect is framed. According to such effect, decision makers tend to underestimate payments that are merely probable, compared to those that are obtained with certainty. Allais showed the irrationality that occurs in decision making in this context. On the other hand, to make risky decisions it is necessary to know how probabilities work. An experimental study was designed to determine the relationships between risk aversion, certainty effect, and basic knowledge of probability theory. In this study it was verified, using a formulation based on the Allais paradox, that those who have more knowledge of the principles of probability show greater aversion to risk. However, the fact of incurring in the certainty effect is a circumstance that is not significantly affected by such knowledge.
Decision-Making under Subjective Risk : Toward a General Theory of Pessimism ∗
2014
The primary objective of this paper is to develop a framework in which a decisionmaker may have subjective beliefs about the “riskiness” of prospects, even though the risk structure of these prospects is objectively specified. Put differently, we investigate preferences over risky alternatives by postulating that such preferences arise from more basic preferences that act on the subjective transformations of these prospects. This allows deriving a theory of preferences over lotteries with distorted probabilities and provides information about the structure of such distortions. In particular, we are able to formulate a behavioral trait such as “pessimism” in the context of risk (independently of any sort of utility representation) as a particular manifestation of the uncertainty aversion phenomenon. Our framework also provides a strong connection between the notions of aversion to ambiguity and risk which are regarded as distinct traits in decision theory. JEL Classification: D11, D81.
Economics Letters, 1979
Diamond and Stiglitz' approach to defining increased risk is developed, and partial orderings emerge which are closely connected with the risk orderings of Meyer. The new orderings are related to behaviour at the extremes of risk aversion and risk loving.
2018
The main focus of this tutorial/review is on presenting Prospect Theory in the context of the still ongoing debate between the behavioral (mainly descriptive) and the classical (mainly normative) approach in decision theory under risk and uncertainty. The goal is to discuss Prospect Theory vs. Expected Utility in a comparative way. We discuss: a) which assumptions (implicit and explicit) of the classical theory are being questioned in Prospect Theory; b) how does the theory incorporate robust experimental evidence, striving, at the same time, to find the right balance between the basic rationality postulates of Expected Utility (e.g. monotonicity wrt. First-Order Stochastic Dominance), psychological plausibility and mathematical elegance; c) how are risk attitudes modeled in the theory. In particular we discuss prospect stochastic dominance and the three-pillar structure of modeling risk attitudes in Prospect Theory involving: the non-additive decision weights with lower and upper s...
The Psychology of Risk: A Brief Primer
SSRN Electronic Journal, 1999
Risk is commonly defined in negative terms-the probability of suffering loss, or factors and actions involving uncertain dangers or hazards. In contrast, the definition used in the social sciences relies on simply the degree of uncertainty-how much variance exists among the possible outcomes associated with a particular choice or action. Counter to intuition, an investment that will lose 5forcertainwouldthereforebeclassifiedaslessriskythanonethathasanequalchanceofyieldingeitheragainof5 for certain would therefore be classified as less risky than one that has an equal chance of yielding either a gain of 5forcertainwouldthereforebeclassifiedaslessriskythanonethathasanequalchanceofyieldingeitheragainof10 or a gain of $15. Uncertainty and value are treated as separable entities because expanding the notion of risk to include gains as well as losses adds considerable conceptual power. For example, depending on how a pair of options is described, a choice can appear as if between two losses or between two gains. Consider the following: Problem I: Imagine that you are faced with a life or death choice. The U.S. has safely quarantined all 600 people infected with an unusual virus, but is now certain that they will all die without some treatment. Resources are severely limited and the choice mast be made between two scienttjk programs. Program A: If adopted, 2cO people will be saved for certain. Program B: If adopted, there is a IN probability that 600 people will be saved and a 2/3 probability that no people will be saved. People choose A over B by a ratio of three to one, showing a preference for the certain outcome. Now consider the same scenario with a different set of choices. Program C: if adopted, 400 people will die for certain. Program D: If adopted, there is a l/3 probability that no people will die and a 213 probability that 600 people will die. People choose D over C by a ratio of four to one, showing a preference for risk. However, note that the end results of A and C are exactly the same-200 people alive, 400 dead-as are those of B and D. According to classical theories of rationality, one cannot both prefer A to B and D to C. This paper will discuss why most people do. Economic theories based on "perfect" rationality are undoubtedly powerful. If one wanted to describe or predict human behavior in the simplest possible manner, one would certainly want to begin by assuming (1) that people are motivated by their own self interests, and (2) that they can be extremely calculating when valuable opportunities arise, learning quickly from the success of others. Research on the psychology of risk does not begin by assuming that all human behavior is irrational, random, or thoughtless. Rather this research has centered on how people may be biased by
Social Science Research Network, 2020
Risk aversion is typically inferred from real or hypothetical choices over risky lotteries, but such "untutored" choices may reflect mistakes rather than preferences. We develop a procedure to disentangle preferences from mistakes: after eliciting untutored choices, we confront participants with their choices that are inconsistent with expected-utility axioms (broken down enough to be self-evident) and allow them to reconsider their choices. We demonstrate this procedure via a survey about hypothetical retirement investment choices administered to 596 Cornell students. We find that, on average, reconsidered choices are more consistent with almost all expected-utility axioms, with one exception related to regret.
The relevance of a probabilistic mindset in risky choice
Proceedings of the 33rd Annual Conference of the Cognitive Science Society, 2011
Choice preferences can shift depending on whether outcome and probability information about the options are provided in a description or learned from the experience of sampling. We explored whether this description-experience “gap” could be explained as a difference in probabilistic mindset, that is, the explicit consideration of probability information in the former but not the latter. We replicated the gap but found little evidence to support our main hypothesis.