topic 7 - risk preferences

risk aversion

avoid a particular kind of risk

certainty equivalent

makes them indifferent between taking an offer vs. a gamble

• number that satisfies the equation:U(CE) = EU(G)

risk premium

how much a person is willing to give up to avoid (seek) the rish

• difference between EV of a gamble and the CE:

  • EV(G) - CE(G)

rabins calibration theorem

people who are moderately risk averse over small stakes must - as a matter of mathematical necessity - be absurdly risk averse over large stakes

Samuelson bet

• risk aversion over small stakes

  • combining multiple of these gambles changes behavior

• implication: assessing risk in isolation yields different behavior compared to viewing many risky decisions together

  • narrow bracketing of decisions + myopic loss aversion

• gains will tend to outweigh losses in the long run

equity premium puzzle

• given difference in returns, why does anyone buy bonds

• explanation:

  • loss aversion

    • not sufficient, as these are better than fair gambles in the long run

  • mental accounting: the way individuals and households keep track of an evaluate financial transactions → “how often is a portfolio checked?” myopic loss aversion