Risk Preference - Literature review Example

Literature review

The study aims on determining the features of stakeholder that are related to risk preference. More risk preference people are likely to be from all the age group and have more information on investment and wealth. Risk preference can be predicted in various ways. For examples, through risk aversion, risk neutrality and risk seeking. People have a tendency to be risk seeking when it comes to damages. Therefore, risk seekers would risk incurring a big loss in than incurring a smaller damage (Roy & Wagenvoort, 1995, P. 76). Moreover, the research will discuss the most shared observed approaches of risk. For instance, the risk that results due to lack of control and possibility of causing serious harm, then unidentified risk, which are suspected to have little information on the possibility of risk happening. Lastly, the other approach will be about how many people are exposed to risk.

The study evaluates whether individual’s risk decision influences the type of choice an individual considers and the effects. In addition, it studies the assumption that those who understand risk, are expected to be creative and ready to change. This study brings the idea of individual risk preference then followed by the discussion of the methods that have been used to measure individual risk preference.

The research aims at measuring how risk preference is important to choice making in both ones behavior and management of administrative. For an individual to make decisions, the expected utility theory explains, the individual has to reflect both the failure and possibility of getting the payments hence, allowing him to make better choices. Nevertheless, the research aims at discussing how to let individual make certain decisions. Therefore, one important factor to be considered is the need of individual to accept different types of risk.

The research paper generally looks at the various theory of risk methods .The organization that applies this theory, on making a risky choice decision, will be able to influence the individual’s choices.

Risk aversion is a trend of investors avoiding unnecessary risk. It is personal because, some investors have different understanding of unnecessary. An investor who focuses on investing on larger investment is prone to more risk, as compared to the investor who is not willing to invest in a larger investment. Because; the investor with smaller investment only needs a small amount of income and therefore would not opt for a more risky asset approach. (Roy & Wagenvoort, 1995, P.76). Moreover, most financial managers are mostly risk averse because, when given two investments with the same income and different types of risk; they would choose the investment with smaller risk preference. Thus, in difference to risk neutral individuals, risk averse investors care not only about the possibility of incurring loss, but also about the possibility of the extent of losses. Consequently, general types of experts’ guidelines can give various types of risk aversion. A decision maker is strongly risk averse if they do not agree to any general method of maintaining the spread of risk. Additionally, risk neutral investor positively oversees risk in deciding the type of investment to be developed. Given the two savings with different types of risk, a risk neutral investor will only be focused on the possibility of getting profit from each investment. This implies that, being risk neutral is different from both risk aversion and risk seeking.

Expected utility theory states that when an individual makes decision, in as much as they depend on their expected results, it is also important to consider the unexpected results. Furtheremore, On the other hand, expected utility theory, does not need the idea of self-interest. Instead, each individual’s thinking is measured using different methods. Firstly, the One that is entirely concerned with the individual’s personal interest and the individual’s feeling when making choice (Roy & Wagenvoort, 1995, p. 76).

When an individual regards expected utility theory to be an issue of personal preference mostly faces difficulty in making choices. Those who know utilities in terms of individual preference, face special challenge. Consequently, risk seeking is a method of risk where a person is prepared to accept during negotiation. For instance, a person who decides to bet on either results rather than accepting the sure option because he expects that he will gain more in betting, will be considered a risk seeker.

Utility theory does not change customer theory. Instead, it supports the idea of consumer theory of selections over risky outcomes. Moreover, it defines how a customer might select between risky choices. However, theories that do not support expected utility theory are very complex that expects developments that require many considerations. This is due to machina’s study of protection that results from expected utility theory (George, 2004, p. 65). The proper report of the theory is the freedom in the case of making a risk choice and the agreed opinion in the case of choice making by not knowing the expected results. (George, 2004, p. 65).

How risk averse are humans

Based on Arrow Pratt model, there is proof that human beings attempt to evade risk in both bodily and economic searches (Pratt). For instance, the similar individual who sets his life at danger ascending mountains might decline to drive a vehicle lacking seat belt or capitalize in shares, because, he deliberates them to be excessively risky.Moreover,some persons are risk players on slight bets but develop more risk averse on stakes with bigger financial consequences. Risk compelling behavior change as individuals mature older, grow into wealthier, and have children. In overall, understanding whatever risk is and in what way to tackle it is the main stage to efficiently handle the risk (Pratt).

Numerous studies on risk aversion have gone from analyzing whether humans are risk averse and if so, how much difference of risk aversion are available across several groups categorized by either, gender, age and returns. So, to clarify this, many of the conclusions are classified as follows:

The level of risk aversion for instance, several research have demonstrated the suggestion that, expected utility theory did not view the guiding tests and therefore, human acted a very difficult behavior than the expectations of the theory(Roy & Wagenvoort, 1995, p. 76).Consequently, studies concerning to human issues have generally decided that they are risk averse. However, there are different types in risk aversion that is determined by the type of stake and how study has been planned (Koornstra, 2007, p. 89). Therefore, in summary, there appears to be strong suggestion that human beings are jointly risk averse. There is also additional proof of important variations in risk aversion through people who shows various signs of risk aversion and some even looking for different types of risk (Roy & Wagenvoort, 1995, p. 76).

More investigational studies of risk aversion specify that, the risk aversion of human differ depending on the type of investigation. For instance, risk aversion factors that emerge, when one has won in competitions choices, may vary from those that emerge from investigative sales, with the similar individuals.Consequently,the individual will behave differently with various organized auctions and risk aversio.Therefore,there is some proof that, risk aversion can be influenced by giving more facts about possible results in a research(Roy & Wagenvoort, 1995, p. 76). This occurs mostly in the situation of loss aversion where, the trend of human to be more concerned to losses than the same gains and be able to assess himself or herself more regularly.so it is important to suggest, the risk aversion of human is influenced by the selections they are presented with, but on the location in which these choices are offered. Consequently, the similar asset can be observed as riskier if presented in various settings and at a different period to the same person (Roy & Wagenvoort, 1995, p. 76).

The type of risk aversion is eventually an observed issue and extra investigations are expected to develop indication that supports field explanations. Through, developing cautious controls of likelihoods and failure. For instance, investigational research that include permanent gambles for lower risks, and bigger number of returns of similar difficulties (Koornstra, 2007, p. 89). These appearances of research betting complicate the understanding of the results and prevent their impression. Through the eversion, the method of theoretical choices increases as the simplest method through which a good number of theoretical questions can be investigated. The technique is influenced by the theory that individuals often understand how they would behave in real situations of choice. (Roy & Wagenvoort, 1995, 76).

The multiple price method allows the individual to be offered with several selections among gambles as various price list.Holt and Lauryl promoted the several price methods using the technique to measure risk factors of a value function. This has made various investigators to discuss this kind of method as a quantity of risk aversion. Consequently, this method has allowed researchers to relate risk methods across a wide-ranging selection of settings and surroundings (Roy & Wagenvoort, 1995, p.76). Contestants are always offered with a list of several choices among the same gambles. Then the contestants select which gamble is favorite for them to play from each pair selecting whichever option that is available. In addition, this method has been used to assess risk preferences in numerous settings. For instance, the technique is used to establish that low reasoning ability is related with greater risk aversion that controls demographic issues. Consequently, the method has been used to estimate the period discount factors and risk quantities for specific types of selection (Lorange & Norman, 1991, p. 67).

One of the key difficulties of multipart methods of causing risk preference is that, a good number of individual’s focuses will fail to recognize the process. This therefore, decreases the importance of the risk preference; this can be actually results to affecting the results. With the normal multiple price list technique, people are normally allowed to change easily among numerous options as they advance down the choice rows. As such, the members may make unpredictable choices either by exchanging more than once or creating backwards selections. Consequently, there is argument that, many inconsistencies points may show insignificance between the selections since; many price lists normally do not contain a clear option to show indifference.

There is also the use of inflatable analogue risk task technique that determines risk choices by offering persons with a computer imitation of inflating air into a sequence of balloons. This technique aims to bring about risk preference in a setting that is conversant and easy to understand. Consequently, the technique has been used to study risk approaches through a range of subfields (Lorange & Norman, 1991, p. 67).However, it is not strong if risk preference drawn through these technique spread to other areas particularly financial decision making. Alternatively, if the method is linked to the risk preference through other approaches (Roy & Wagenvoort, 1995, p. 76).

The elicitation mode of Gneezy and potters offer a degree of risk preferences in the perspective of monetary choice making with the actual monetary incomes. Here, the individual who makes decision gets a certain amount of cash and is requested to decide how much of the amount of money she desires to spend in a risky selection, and how much to save. At the end, there will be the production of the anticipated value of capitalizing which will be greater than the anticipated price of not investing. For that reason, this suggests that, a risk neutral individual should invest for money provided while a risk averse individual may possibly decide to invest less.

When we think through the situation in which the members receives a donation of 100 cents. That woman is then requested to select what part of this donation amount of money she would like to capitalize in a risky asset, and how much to keep. The risky asset earns double the amount of money capitalized with likelihood of one half and zero probability of one half.as a result, the contestant saves the amount of money that she does not capitalize, hereafter, the outstanding amount of money that is not capitalized is used as the degree of the risk preference.

On the other hand, it is important to say, risk neutral persons should invest their whole donations. Because, it cannot differentiate between risk seeking and risk neutral preference.However,risk seeking preference seems to be moderately uncommon, and equally small portion of contestants choose to capitalize the whole amount of money. The technique has been used to arrange for support for biased loss aversion in the monetary choices of learners as well as expert traders.Subsequently,the technique has also been used to display a confident link between risk taking and facial manhood and to relate sex variations in risk attitudes.Moreover,the comparative easiness of the technique, that is joined with the statistic that, it can be applied with one experimental using basic experimental tools, makes it a significant tool for measuring risk preferences in the field.

Inquiry form is a frequently used technique of encouraging risk preferences that depend on the person’s self-reported tendency for risk. A usual question at all times comes in the formula of; rate your preparedness to take risks in all-purpose. Such common inquiries indirectly undertake that they are a distinct, steady risk preference that encourages conduct through numerous fields. In turn, risk preference resulting through this technique are usually used as signs for the tendency to involve in bahaviour.Nevertheless,a considerable amount of confirmation proposes that, the measured risk preference are extremely reliant on on the areas in which they are produced.

How risk averse are people in the reality

The elicitation technique, specifically the Holt and Laury established that the risk likings measures were affected by the kind of technique used and established that percentage risk approaches were context-dependent (A and Susan). Moreover, persons obviously differ and may have an influence on the risk approaches. For instance, when considering if women are more risk averse in reality than men, the difference percentage would be much less observable in everyday life.Therefore,a significant share of 64% of the male lies beyond the female in risk averse in reality(A and Susan).

Prospect theory suggests expressive outline for the way individual make choices under situations of risk and demonstrates a better off behavioral outline than that of individual anticipated utility theory, that causes several economic ideal and rational(Cox & Harrison, 2008, p. 34). Loss aversion is based on the impression that the psychological consequence related to a given loss is bigger than the psychological reward from achievement of the same size (Oliver & Weitz, 1991, p. 200). Therefore, individuals are risk averse in reality because most of the business people compare the outcome of the business in terms of profits and loss basing on the argument of different models.Because,most of the individuals cannot lose what they do not have(Meyer & Meyer, 2006, 78).

When losses turn into reality, it become obvious that, all investors are really loss averse. For instance, the investors who most of the times maintains the standard of the business and knows that the business may have loss. (Roy & Wagenvoort, 1995, 76). Usually, the return objective of old-style reasonable income is determined by a normal method. Prospect concept is used to define how individual manages risk and a steady decision that when results are outlined as positive gains, people are more risk averse; nevertheless, in the same circumstances when the results are badly regarded as losses, people become risk seeking (Meyer & Meyer, 2006, p. 78). Therefore, individuals in gain edge desire certain positive results over betting for the possible larger positive result, which recommends that when individuals have money, they have gained (Oliver & Weitz, 1991, p. 200). Nevertheless, when the results are offered in a different way and outlined in terms of losses, people’s preference change. Individual select the correct decision to prevent a certain loss as certainty is excessive relating to the occurrence of the loss (Meyer & Meyer, 2006, p. 78). Gamblers need to fear betting because of the losses and uncertainties connected to betting. Therefore, the important feature of prospect theory is that, the anger that is related to losing amount of money that is usually bigger than the desire related with the same amount (Roy & Wagenvoort, 1995, p. 76).

In certainty, individuals often make financial choice when the view is not decided and carries with it the danger of loss. For instance, when an individual chooses to construct in a coastal area with lack of proper understanding of the future events. However, it is always likely for the individuals to use market in order to avert their risks (Roy & Wagenvoort, 1995, p. 76). Nevertheless, financial theory assumes normal financial players and risk averse behavior. However, this is a theory that only few individuals always and completely support. Economic thinking even appears to be in obvious division to a great choice of risky behaviors and logic of seeking as experimentally conducted in reality (Roy & Wagenvoort, 1995, p. 76).

Conclusion

In conclusion, demographic issues like age have been used to differentiate various stages of risk preferences. Demographic features look like it only provide a starting point in evaluating the acceptance of investor risk tolerance. Risk tolerance groups, economic organizers, and investment directors use demographic variables which enhance the distinctive of the three levels of risk preference. Moreover, the variables of gender appear to offer the best discriminating power when used to determine into which level of risk preference a potential client will most likely prefer.

As this research indicate, having more knowledge on risk tolerance is a difficult process that goes further than the limited use of demographics. Furthermore, risk preference is not just a modest of one dimensional or numerous approach, it may possibly be sub-dimensional. Equally, classifying individual’s risk preference is very difficult and not an easy task, several understandings must be provided in order to establish suitable category of classifying one into investor risk tolerance. Consequently, it is important to go beyond the common individual method of basing on personal characteristics in order to understand which kind of risk preference investor belongs in. Therefore, further research is necessary in order to determine which further aspects such as, anticipations, proficiencies, approaches, family background, or asset directors to increase the clarified discrepancy in risk tolerance dissimilarities can use economic stability.