The Impact of Skewness on Risk Aversion Elicitation in Binary Lotteries

Abstract

Parametric and non-parametric risk aversion is often elicited through binary lotteries. Basing ourselves on recent evidence of the higher than theorized importance of skewness in decision making, we highlight in this paper that skewness might bias the result of risk aversion elicitation in two ways. First, subjects might favor binary lotteries displaying more skewness and more variance, which we term the prudence bias. Second, if a high level of positive skewness is observed across the pair, it may push subjects to take on more second order risk, which we term the level bias. We analyze the most prominent experimental methodologies of risk aversion elicitation in light of these two biases. More generally, we stress out the need to control for higher orders of risk when eliciting risk aversion of order n. In addition, these biases might explain real world phenomena, such as the purchase of lottery bonds, out of the money options or more generally betting behaviors that are difficult to explain through classic theory.