Understanding the Two Components of Risk Attitudes : An Experimental Analysis

Economics and management science share the tradition of ordering risk aversion by fitting the best expected utility (EU) model with a utility function of certain parametric form to individual data, and then using the individual utility curvature as the sole index of risk attitudes. (Cumulative) Prospect theory (CPT) has demonstrated various empirical deficiencies of EU and introduced the weighting of probabilities as an additional component to capture risk attitudes. However, CPT would have been a less significant challenge to EU if utility curvature and probability weighting were strongly correlated. Because then the utility curvature in EU alone, while not properly describing risky behavior in general, would still capture most of the variance of individual risk aversion. This study shows, however, that such a strong correlation does not exist. Though, most individuals exhibit concave utility and convex probability weighting, the two components show no significant correlation. Thus neglecting one component entails a loss