This preview shows page 1. Sign up to view the full content.
Unformatted text preview: ay in which he noted a
widespread preference for risk aversion. In an often referred to article in Scientific 87 American in the 1980s Daniel Kahneman and Amos Tversky gave a simple example
of risk aversion (Kahneman and Tversky, 1982). Imagine you are given a choice
between two options. The first is a sure gain of $80, the second a more risky project
in which there is an 85% chance of winning $100 and a 15% chance of winning
nothing. With the certain outcome you are assured of $80. With the riskier option
your EMV would be $85 ($100*0.85 plus $0*0.15). Most people, say Kahneman and
Tversky, prefer the certain gain to the gamble, despite the fact that the gamble has a
higher EMV than the certain outcome (Bailey et al., in press).
In 1944, von Neumannn and Morgenstern expanded preference theory and proposed
that the fundamental logic of rational decision-making could be described by eight
axioms that are paraphrased in the following statement:
“Decision-makers are generally risk averse and dislike incurring a loss of $X
to a greater degree than they enjoy making a profit of $X. As a result, they
will tend to accept a greater risk to avoid a loss than to make a gain of the
same amount. They also derive greater pleasure from an increase in profit
from $X to $X+1 than they would from $10X to $10X+1 ” (Bailey et al., in
They went on to show that if a decision-maker had a value system which was
described by these axioms, then there existed a function, or curve, which completely
described his attitude and feelings about money (Newendorp, 1996 p152). This curve
is known as a preference, or utility curve. An example of a preference curve is shown
in figure 5.5. Pleasure Increasing preference
or desirability Increasing amounts of money (or some other criterion) Pain 88 Figure 5.5: A preference curve (source: adapted from Newendorp, 1996 p147) According to risk consultant Peter Rose (1987), a preference curve shows two things:
• The pleasure (utility) associated with winning is generally less than the
displeasure of losing the same amount (that is, it hurts more to lose than it feels
good to win.) People will take a greater chance to avoid a loss than to make a gain
of the same amount. • People feel more pleasure about gaining $10 going from, say, $10 to $20, than
they do about gaining $10 going from $1500 to $1510. Theoretically at least it is possible to draw just such a curve for any individual.
Different shaped curves would denote different types of decision-maker. The shape
of the curve in the lower left-hand quadrant describes how the individual feels about
loss and the one in the upper right quadrant is the individual’s attitude to risk and the
levels of profit associated with risk. Many writers have categorised decision-makers
according to the shape of their preference curves. In general, these authors perceive
there to be three types of decision-maker: risk averters, average players (who would
always choose the decision alternative with the maximum EMV) and risk-seekers.
Each, they believe, has a distinctive preference curve. These curves are shown in
figure 5.6. As indicated above, exten...
View Full Document
- Summer '14
- The Land