Even slight risk aversion over small stakes implies massive risk aversion over large stakes. We can’t explain real-world risk aversion just by diminishing marginal utility.
To see what else might be needed let’s return to an idea from an earlier article loss aversion. As a reminder, loss aversion means that economic losses influence our decisions more than economic gains, on average about twice as much.
This phenomenon affects the way people think about risky decisions if people think about risky options as evolving losses and gains at least from the reference point of the safe option their subjective sense of potential loss can readily outweigh their sense of potential gain.
So far I’ve emphasized risk aversion and having given any examples of risk seeking behavior. Part of that is because risk seeking is often inefficient. If someone is truly risk seeking over monetary gains than they can be exploited, they’ll be willing to take bad that after bad debt much like the pathological gambler who can’t walk away from the table.
But what about monetary losses ? Do people tend to be risk-averse or risk seeking when faced with decisions that involve risky losses versus sure losses? This is a much harder question.
A moment’s intuition might suggest that people are more averse to losses than to gains then they might even be more risk-averse for decisions involving losses. Let’s consider this question from a behavioral economics perspective. Prospect theory proposed that people have diminishing marginal utility for both gains and losses.
That is the difference between losing zero dollars losing $100 might be pretty bad, but the difference between losing $1000 and losing $1100 isn’t anywhere near as great.
Decisions involving risk
So what is this fact mean for decisions involving risk? It’s worse to be sure but it isn’t twice as bad. People tend to be risk-averse when making decisions about potential gains, but people tend to be risk seeking when making decisions about potential losses.
Obviously the term risk is applied to many other things other than the financial decisions. When we describe one of our friends is risk-averse we usually don’t mean to imply that we’ve look at their portfolio and seen a preponderance of bonds or stocks.
Instead we mean that they don’t like to try new things, that they are afraid of physical challenges or that they are happy with her current state. This raises an obvious question: Are our risk attitudes a stable personality trait, something like extraversion? Are they something that shape all of our choices?
The answer might seem obviously yes we can readily bring to mind stereotypes of stodgy bankers who invest conservatively dress conservatively and have surely never bungee jumped in their life. But those stereotypes are hardly data.
The decision expert Elke Weber and her colleagues explored this question by asking participants questions about how often they engaged in different sorts of risk-taking behaviors.
Some were investment behaviors, like investing 5% of your annual income in a very speculative stock, others were recreational behaviors, like piloting your own small plate and others involve social behaviors like approaching your boss to ask for a raise and still others involve gambling health-related or ethical behaviors.
If attitudes toward risk represent a stable personality trait the people who frequently engage in one type of risky behavior would be more likely to engage in the other types of risky behavior, but that’s not what Weber found. Instead these different risky behaviors form separate categories that were not strongly correlated.