Posted: September 1st, 2023

Risk Preference

Risk Preference
Uncertainties often leave people unsure about the outcomes of certain options available to them. This occurs when both choices have positive and negative promises in almost equal measure. This is where risk tolerance becomes important and turns the attention back to the individual with the choices to make. Since the risks are known, it is imperative that an individual decide: Certain tools are designed to aid in that process. For these tools to be effective, it is paramount that verbal descriptions be converted into numbers. It is difficult to analyze an actual risk with words like “fairly” or “most probably” as they are vague. It’s tough and quite impossible to know how to exhaustively describe probabilities verbally, while numbers ease the process. Solving probabilities help in determining the risk involved and how to wisely tackle various choices available.
Using the basic tree as depicted in the Graph 1 the initial assessment shows that there is the likelihood of a 60% chance the market will go up. The risk assessment in this case is heavily dependent on the figures obtained and also assessing the risk based on what we want. This is also referred to as risk tolerance. Using the decision tree, we can confidently conclude that it is worth investing the $1000 in the risky investment branch for the returns are higher and the chances of the investment being unfavorable are lower as compared to the other investments.
In the second graph, the chances of having a better output among the three investments are seen to being investing in the second option. From the analysis using the decision tree it is clear that the most rewarding option is the risky investment should the market turn out well. By using it, the chances of having good returns are higher and the chances of the investment being unfavorable are lower.
Running a sensitivity analysis as shown in the third SA graph shows us three ranges. Chances are that this will not be the last time the $1000 investment will be made. In situations where the stakes are relatively small yet the risks will be taken repeatedly, it is advisable to average out the winners and losers over that period of time. This is the aim of EMV. However this is dependent on the amount of investment and who is making it. Some amounts may seem large to individuals but rather small to others. The risk in the three investments is close and a choice of investing in any will depend on an individual preference.
Risk taking does affect the decisions. This is where risk aversion comes in. It is measured by establishing the difference between what one is willing to pay for an investment and the expected value of the particular investment. However, all the analysis carried put using the computer is based on expected values. In real circumstances, expected values are made based on reasonable choices. The analysis of how much one is willing to loose and the potential gains becomes very crucial.
Once a good understanding of the risk is achieved, a decision is made on whether the risk is worth taking or not, which depends to a good extent on an individual attitude towards risks. Here the risk tolerance is considered. For example, it is unlikely for a person to accept a 50/50 bet that in turn pays $20 in case of a win but costs $10 in case of a lose.
Depending on how one base his analysis either on desirability scores or preference scores, risk problems tend to take care of themselves. In most cases, people take choices that are likely to yield most and with least chances of losing. If an individual is offered a 50/50 choice of $1,000 in case of a win, $0 in case of a loss, and $500 guaranteed, the guaranteed option is the most likely option to choose. It is factual to say that, the RPF gives thorough breakdown of the outcomes and offers broader analysis.
After obtaining the risk preferences as seen in graph 5, it is preferable to analyze the tree using the preferences and not the EMV alone. In such a case the analysis will be different since the expected values as seen in the graph with rounded corners.
Running a SA based on risk preferences function turned is more effective and detailed as compared to the EMV that factors a limited number of probabilities in its calculations and results. It is also possible to carry out multiple outcomes using RPF and it is fast to interpret.
Conclusion
From our analysis, it is important to know the difference between EMV and EDV analysis. EMV points out the option that yields the highest average amount of money in repeated risks. On the other hand, EDV points out the option that would, averagely, bring about the most desirability points for they in turn reflect one’s true preferences. At times, the EMV and the risk preference (EDV) analysis point to the same conclusion other times, in opposite directions. Such results lead one to think hard about our choices. However, EMV, focus their attention to risk preferences and hence can influence final recommendations very decisively.
It is important to note that risk does not necessarily have to be treated as “take it” or “leave it” options and can often be manipulated by diversifying options and information. However, one thing that should not be done is ignoring the risk. It needs to be carefully assessed.
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