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Understanding Risk Preferences
Baucells, Manel Technical Note QA-0858 / Published March 24, 2017 / 12 pages.
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Product Overview

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 how individuals evaluate risky prospects. The model builds on the distinction between probabilities and decision weights, as well as the notion of framing and loss aversion, as put forward by prospect theory.

Learning Objectives

Convince students not to expect individuals to value risks according to expected value. Introduce the notions of framing, loss aversion, and decision weights, as put forward by prospect theory. Present a behavioral valuation model that replaces the expected value rule.

  • Overview

    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 how individuals evaluate risky prospects. The model builds on the distinction between probabilities and decision weights, as well as the notion of framing and loss aversion, as put forward by prospect theory.

  • Learning Objectives

    Learning Objectives

    Convince students not to expect individuals to value risks according to expected value. Introduce the notions of framing, loss aversion, and decision weights, as put forward by prospect theory. Present a behavioral valuation model that replaces the expected value rule.