Meaning of risk aversion

It is often said that investors are risk averse. What does this mean?

We have alluded to the idea that investors tend not to prefer risk, all things being equal. Consider a couple investment possibilities, each presenting you with a choice between certainty and risk:

• Flip a coin. You can earn a certain $4, or you can flip a coin and receive $10 if it's heads.
• Roll a die. You can receive a certain $30,000, or you can roll a six-sided die and receive $10,000 times whatever number comes up.

In each case, what are the expected returns? Which would you choose? Your answers reflect your risk aversion. Consider the expected return in the coin-flip case --

Consider the expected return in the dice-roll case --

In both cases, your expected return is higher by taking the risk -- that is, flipping the coin or rolling the die. If you already have lunch money and you enjoy thrills, you might forego the certain $4.00 and flip the coin in the hope of $10.00. But if you were worried about paying your school loans (which now total $30,000), you might not want to roll the die, even though on average you could expect to receive $35,000 and perhaps even $60,000. But the risk of rolling a 1 or 2 makes you shy away.

Components of risk aversion

Notice that your risk aversion reflects two components --

• your financial circumstances -- in the coin flip, you already had lunch covered and you were risking discretionary moneys
• the dispersion of the outcomes -- in the die roll, there was a wide range of outcomes (from $10,000 to $60,000) that made you sensitive to variation

BY: ANTONI BOSCH-DOMèNECH
Universitat Pompeu Fabra
Department of Business and Economics
JOAQUIM SILVESTRE
University of California, Davis
Department of Economics
Date: April 20, 2003

Are poor people more or less likely to take money risks than wealthy folks? We find that risk attraction is more prevalent among the wealthy when the amounts of money at risk are small (not surprising, since ten dollars is a smaller amount for a wealthy person than for a poor one), but, interestingly,
for the larger amounts of money at risk the fraction of the nonwealthy displaying risk attraction exceeds that of the wealthy. We also replicate our previous finding that many people display risk attraction for small money amounts, but risk aversion for large ones. We argue that preferences yielding 'risk attraction for small money amounts, together with risk aversion for larger amounts, at all levels of wealth,' while contradicting the expected utility hypothesis, may be well-defined, independently of reference points, on the choice space.

Risk aversion in law

Environmental, health and safety law, as well as corporate law, offer examples of how risk aversion plays a prominent role in legal decisionmaking. But look closely enough, and you will see similar risk assessment and measurement processes at work in virtually any area of public law and policy.

Environmental, health and safety law. Governments role the dice with public health all the time. Volumes of legislation have been enacted into law for the purpose of protecting the welfare of individuals and natural resources. To varying degrees these laws and regulations reflect judgments about what levels of risk society can and should tolerate. How should these risks be assessed?

The rationale for these laws is not always purely altruistic. The legislators who create health and environmental laws and the lawyers and judges who interpret and apply them often couch their function in economic terms. For example, even though they are strictly regulated, asbestos and lead paint can be found in many of the buildings where we live and work. The danger of these substances to human life can hardly be disputed—but yet they remain. Why? The answer is that a politician or administrator made a decision about the risk—that is, a cost-benefit analysis weighing the value of human life against the cost of removing these toxins.

Out of necessity, we speak of these risks in terms of dollar values. How do we value human life? More specifically, how do we value life when the harm done (such as exposure to asbestos) will not manifest symptoms for ten or more years? Some have suggested that, in such situations, public health risk should evaluated in terms of lives endangered reduced to a present dollar value (To state it plainly: What is the value today of losing ten years of life 30 years from now?) See Richard L. Revesz, “Environmental Regulation, Cost-Benefit Analysis, and the Discounting of Human Lives,” 99 Colum. L. Rev. 941 (1999). Others have asked whether we should attempt to value risk in terms of total lives saved or “decently-livable life years”? See Cass R. Sunstein, “Which Risks First,” 1997 U. Chi. Legal F. 101.

A burgeoning field of “contingent valuation” is developing which attempts to value various states of health. For example, some studies have shown that people would be willing to spend more to prevent cancer deaths (from $1.5 million to $9.5 million) than to prevent unforeseen instant deaths (from $1 million to $5 million). Id. (citing Tolley, Kenkel, and Fabian, eds, Valuing Health for Policy: An Economic Approach 341-42).

Corporate law. If you owned stock in a company, would you want the managers in your company to roll the dice or play it safe? Would your answer change if you owned stock in many companies? There has been some interesting writing on this question.

• Some assert that corporate liability rules should not impose liability on managers who roll the dice, even if they lose.
• Some argue that managers should be more responsible and should be liable if they take inappropriate risks -- such as approving corporate illegality.
• Some urge that compensation systems be engineered so managers, who naturally are worried about job security, will be less risk-averse.

Much has been written recently on the lapses in corporate judgment summed up by names like Enron and WorldCom. The type of risk-taking that amounts to no more than corporate fraud is clearly illegal, and the law has well-established rules for dealing with those situations (as evidenced by the ongoing corporate executive “perp walks” we see in the news). Perhaps the more interesting question is how the law deals with those business decisions not so clearly conceived in fraud and deceit.

How do lawyers impact the process of making these business decisions? See Donald C. Langevoort and Robert K. Rasmussen, “Skewing the Results: The Role of Lawyers in Transmitting Legal Rules,” 5 S. Cal. Interdis. L.J. 375 (1997).

Student paper

Here is a student paper that investigates the student's own exposure to liability due to her involvement in nonprofit organizations and activities. Marjorie Benbow, No Good Deed Goes Unpunished.

Certainty equivalence

Financial analysts often equate risk and variability. The greater the variability, the greater the risk -- and vice versa. But why does greater variability translate into greater risk -- and thus a lower valuation? To illustrate this relationship, consider two investment options:

Although the expected return is the same for both, Investment B is riskier. The range of outcomes (variability or volatility) is greater for Investment B.

How much would you pay for Investment A compared to Investment B? Disregarding for now the time value of money, it should be obvious you would pay at least $900 for Investment A -- you are certain to receive at least this. In fact, you would probably pay close to $1,000, given the high likelihood (80%) of earning $1,000 and the small dispersion from the mean. Let's say, you view Investment A and $980 as equivalent. That is, Investment A's "certainty equivalent" is $980.

But Investment B is more volatile and has a different certainty equivalent. You would probably be reluctant to pay even $900 for Investment B, given the significant possibility (30%) of a zero return. Although Investment B's possible returns of $1,000 and $2,000 might be attractive, they are not certain. Perhaps you would pay only $800 for Investment B -- its certainty equivalent.

This illustrates how an asset's riskiness affects its value. The greater the uncertainty of cash flows, the lower their value. Risk can be factored into the valuation process by either increasing the discount rate or decreasing the value of risky returns.