Risk aversion (psychology)

Risk-aversion is a preference for a sure outcome over a gamble with higher or equal expected value. Conversely, the rejection of a sure thing in favor of a gamble of lower or equal expected value is known as risk-seeking behavior.

The psychophysics of chance induce overweighting of sure things and of improbable events, relative to events of moderate probability. Underweighting of moderate and high probabilities relative to sure things contributes to risk-aversion in the realm of gains by reducing the attractiveness of positive gambles. The same effect also contributes to risk-seeking in losses by attenuating the aversiveness of negative gambles. Low probabilities, however, are overweighted, which reverses the pattern described above: low probabilities enhance the value of long-shots and amplify aversion to a small chance of a severe loss. Consequently, people are often risk-seeking in dealing with improbable gains and risk-averse in dealing with unlikely losses.

Most theoretical analyses of risky choices depict each option as a gamble that can yield various outcomes with different probabilities. Widely accepted risk-aversion theories, including Expected Utility Theory (EUT) and Prospect Theory (PT), arrive at risk-aversion only indirectly, as a side effect of how outcomes are valued or how probabilities are judged. In these analyses, a value function indexes the attractiveness of varying outcomes, a weighting function quantifies the impact of probabilities, and value and weight are combined to establish a utility for each course of action. This last step, combining the weight and value in a meaningful way to make a decision, remains sub-optimal in EUT and PT, as people’s psychological assessments of risk do not match objective assessments.

Expected Utility Theory (EUT) poses a utility calculation linearly combining weights and values of the probabilities associated with various outcomes. By presuming that decision-makers themselves incorporate an accurate weighting of probabilities into calculating expected values for their decision-making, EUT assumes that people’s subjective probability-weighting matches objective probability differences, when they are, in reality, exceedingly disparate.

Consider the choice between a prospect that offers an 85% chance to win $1000 (with a 15% chance to win nothing) and the alternative of receiving $800 for sure. A large majority of people prefer the sure thing over the gamble, although the gamble has higher (mathematical) expected value (also known as expectation). The expected value of a monetary gamble is a weighted average, in which each possible outcome is weighted by its probability of occurrence. The expected value of the gamble in this example is .85 X $1000 + .15 X $0 = $850, which exceeds the expected value of $800 associated with the sure thing.

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