Risk and Utility in Decision Making

Risk Aversion

• Definition: Risk averse individuals prefer to avoid uncertainty and potential losses even at the cost of lower potential gains.
• Example: Given a choice to gain $20,000 with 50% probability or lose $20,000, a risk averse person will likely choose not to invest.

Cost-Benefit Analysis

• Individuals perform an informal cost-benefit analysis based on outcomes and their probabilities.
• Example: If investing has a 50% chance of gaining $30,000 or losing $10,000, the expected payoff can be calculated.
• Calculation:
• Expected Value = (0.5 * 30,000) + (0.5 * (-10,000)) = 15,000 - 5,000 = 10,000.

Utility Theory

• Utility: Represents an individual's satisfaction or happiness derived from wealth or goods.
• Diminishing Marginal Utility: As wealth increases, the incremental happiness from each additional dollar decreases.
• Example: Utility from an initial wealth of $80,000 versus increments of wealth beyond that level.
• Risk averse individuals exhibit flatter utility curves, indicating less satisfaction from additional wealth.

Different Degrees of Risk Aversion

• Individuals exhibit varying levels of risk aversion; what might seem like an acceptable risk to one person could be unacceptable to another.
• Example: Some may choose to take a new job with double the salary and a chance of income reduction, while others remain conservative.

Subjective Preference and Decision Making

• Individuals base their decisions on risk based on their current financial situations and life circumstances.
• Example: If $10,000 is a significant hit for someone, they would not accept risky investments even with high potential returns.

Expected Utility

• To quantify decision-making under risk, utility can be assigned to different outcomes and their probabilities calculated.
• Example: If current wealth is $30,000, evaluate the utility of investing that could either lead to $50,000 with 40% probability or a loss resulting in $15,000 with 60% probability.
• Utility Ratings: Assign utility scores using a 0-10 scale based on wealth scenarios.

Risk Intelligence

• Definition: The ability to make well-informed decisions regarding risk based on available information and willingness to adapt beliefs.
• Differences among people in risk evaluation and the importance of self-awareness and information processing in risk taking.
• Example: Professional gamblers often excel at assessing odds not just through chance but through detailed understanding and calculation.

Strategies for Assessing Risk

• Successful risk takers maintain accurate records of their decisions to recognize errors and adapt strategies.
• Gathering information expands the decision-making horizon and improves outcomes.
• Expertise in a domain can enhance risk assessment abilities; being educated about specific situations leads to better informed decisions.

Conclusion

• Evaluating risk involves balancing the potential gains against the possible losses.
• Understanding how personal circumstances affect perceptions of risk can help in making more rational economic decisions.