Individual vs. Aggregate Preferences: The Case of a Small Fish in a Big Pond

Abstract

We study the relationship between the risk preferences of individuals and the risk preferences of the aggregate economy. To emphasize the vast differences that can occur between individual and market preferences brought about through aggregation, we assume an economy consisting entirely of risk seekers. We show that such individuals can lead to an aggregate economy that is risk averse. The converse is also true. An aggregate economy that exhibits risk aversion does not imply an economy of individual risk averters. An economy demanding a risk premium can be formed from individuals who do not demand such compensation. Understanding the relationship between the preferences of individuals and the preferences of the aggregate economy is crucial for understanding the connection between the behavioral finance literature, which focuses on individual preferences, and the asset-pricing literature, which focuses on aggregate prices. We discuss empirical implications of these results. This paper was accepted by Wei Xiong, finance.