Risk Aversion vs Uncertain Outcomes

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Risk aversion is a concept in economics of how people behave when they are exposed to uncertain outcomes. The concept of being risk averse is defined as the propensity to prefer an offer with an expected lower but more certain outcome, compared to an offer with a higher expected outcome with more risk. A more risk averse person is thus less inclined to make an investment with a fairly rewarding outcome if the outcome is uncertain, than a person who is less risk averse. In a stone age society with everyday real and present threats and dangers (and many deadly ones too), such a mental setting would seem adaptive and evolutionary wise.

For a poor person in todays world, this might imply little or no investment in modern production technologies that could lead that person out of poverty. Knowledge of risk behavior might therefore be of importance for someone who wants to make informed, but at times, risky choices that could better his or her life. Because, as Amos Tversky and Daniel Kahneman demonstrated in their theory about decision theoryloss aversion is people’s tendency to strongly prefer avoiding losses than acquiring gains. Several studies suggest that losses are twice as powerful, psychologically, as gains, which leads to risk aversion; since people prefer avoiding losses to making gains.

Risk aversion might explain why people in the stock market hold on to stocks that are at their peak (but will probably go down), but are notorious reluctant to sell stocks that lose value before it reaches rock bottom, but will sell at its lowest point (where it most probably will start to go up again). In statistics we know about regression toward the mean, which is the phenomenon that if a variable is extreme on its first measurement, it will tend to be closer to the average on its second measurement. If people knew more about these three things; loss aversion based on feelings (and not cognition), calculated risk behavior based on cognition (and not feelings) and regression toward the mean, wealth might be more evenly distributed in society?

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3 Responses to Risk Aversion vs Uncertain Outcomes

  1. Hariod Brawn says:

    Now I know why I am skint! Thanks Jarle, for another excellent article.

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