Risk Preferences

Applied Economics

University of Michigan Ross School of Business

Expected Value

If people made their choices to maximize expected value, they would always choose the option with the highest expected value regardless of the risks involved.

This is what risk-neutral individuals do.

Expected Value

Risk neutral: indifferent between a sure outcome and an uncertain outcome with the same expected value

Risk averse: preference for a sure outcome over an uncertain outcome with the same expected value
To avoid risk, a risk averse person will be willing to pay a premium.
Alternatively, such a person will require extra compensation to get them to accept a risk
     
Risk loving: preference for an uncertain outcome over a sure outcome with the same expected value

Expected Value

Risk neutral,  Risk averse,  Risk loving are three categories that describe individuals' risk preferences -- that is, how individuals feel about bearing risk.

Expected Value

If Sofia is willing to pay up to $450 for insurance against a loss of $7000 which will occur with a 5% probability, she is: 

(a) Risk-neutral
(b) Risk-averse
(c) Risk-loving 

If you knew that Sofia is risk averse, would you be able to say that she would be willing to pay $450 for insurance against this loss? What prediction could you make exactly?

Expected Value

 Sofia is risk averse because she would be willing to pay money to get rid of the risk.

Sofia's expected loss = $7,000*0.05 = $350

We can say she is willing to pay more than $350.
How much more? That depends on “how much” averse to risk she is.

Expected Value

Risk averse people choose actions or situations with higher risk only if the expected value is higher than that of a less risky alternative--hence the market relationship between risk and return in Finance.

Risk-neutral players maximize expected values.

Risk-averse people (i.e. most of us most of the time!) maximize their expected “utility” or “well-being” - not expected value.