Risk aversion

Risk aversion is a concept in psychology, economics and finance theory explaining the behaviour of consumers and investors under uncertainty. Risk aversion occurs when a person is willing to accept a lower expected payoff if it means they can have a more predictable outcome. For a more general discussion see the main article risk.

Limitations

The notion of (constant) risk aversion has come under criticism from behavioral economics. According to Matthew Rabin of Berkeley, a consumer who,

Related Topics:
Behavioral economics - Matthew Rabin - Berkeley

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from any initial wealth level turns down gambles where she loses $100 or gains $110, each with 50% probability will turn down 50-50 bets of losing $1,000 or gaining any sum of money.

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Rabin claims that this effect brings doubt upon the applicability of utility theory. However, it should be noted that examples such as this one hinge on the assumption that the consumer turns down the low-stakes gamble no matter what their initial wealth. The usual criticism of this assumption is that the existence of such a consumer is highly dubious. See http://arielrubinstein.tau.ac.il/papers/rabin3.pdf for more on this.

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A perhaps more believable criticism of utility theory is the difficulty by laypersons of estimating very small probabilities and the preference of gains versus losses (loss aversion).

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Experiments with primates suggest risk aversion is a hard-wired biological behaviourhttp://www.economist.com/science/displayStory.cfm?story_id=4102350.

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