Risk Preferences and the Perceived Value of a Risk Profile

Abstract

MBA students are taught to use the expected monetary value (EV) to evaluate risky opportunities. The reaction of individuals to risk, however, is far more complex. In fact, individuals are rarely found to be consistently risk neutral, risk averse, or risk seeking. They can be all these things, depending on whether the probabilities are small or large or the outcomes are gains or losses. The purpose of this note is to introduce a behavioral model that modifies EV and does a better job of predicting the perceived value of a risk profile. The model builds on the distinction between probabilities and decision weights, as well as the notions of framing and loss aversion, as put forward by prospect theory.Supplements to the note include a video and an Excel spreadsheet to aid student understanding. Excerpt UVA-QA-0858 Rev. Nov. 26, 2018 Risk Preferences and the Perceived Value of a Risk Profile MBA students are taught to be risk neutral and use expected monetary value (EV) to evaluate risky opportunities. The reaction of individuals to risk, however, is far more complex. In fact, individuals are rarely found to be consistently risk neutral, risk averse, or risk seeking. They can be all these things, depending on whether the probabilities are small or large and on whether the outcomes are gains or losses. The purpose of this note is to introduce a behavioral model that modifies EV and does a better job of predicting how individuals evaluate a risk profile. The model builds on the distinction between probabilities and decision weights, as well as the notions of framing and loss aversion, as put forward by prospect theory. To set the stage, we begin by noting that many important risks involve small probabilities and multiple sources. These include risks of accidents, health risks, and risks of being the victim of a fraud or a crime. Table 1 collects some of the odds listed in Larry Laudan's classic, The Book of Risks: Fascinating Facts About the Chances We Take Every Day, based on the U.S. population: Table 1. Laudan's risks and odds. . . .