Navigating Risk Aversion and Regret

Abstract

This study investigates the distinctive modeling of regret utility when compared with common utility. I also introduce the interplay between common utility and regret utility. Using this model, I examine the differences in decision making, which encompasses issues such as risk sharing and principal–agent dilemmas. Regret utility is set so that its risk aversion shows common utility’s prudence (i.e., downside risk aversion). This paper reveals, both qualitatively and quantitively and with a concrete model, that regret utility leads to a more balanced and optimal ratio of agent payouts to outputs compared with common utility, meaning when major outputs are kept by principal, there are relatively larger agent payouts, and when major outputs are kept by the agent, there are relatively smaller agent payouts. This means that regret makes a more balanced distribution, and regret utility is more conservative (not biased). In addition, preliminary empirical research was performed in which people were asked risk preference or averseness questions, and their risk averseness was calculated by using the CRRA (Constant Relative Risk Aversion) utility function. The regret condition leads to a more conservative attitude. Furthermore, the regret model can be used in other areas, like in conservative investment portfolio optimization.