Modeling the economic impact of individual and corporate risk attitude

Abstract

Walls’ work [1, 2], based around Expected Utility Theory [3], has highlighted the relationship between corporate risk tolerance and value; and others have commented on the loss of value resulting from companies behaving in a non-risk-neutral manner (i.e. not using expected value (EV) to make decisions) [4]. Prospect Theory [5], however, extends Utility Theory [3] to describe decisions individuals actually make under uncertainty. Key features include: diminishing utility of returns, resulting in risk aversion for gains and risk seeking for losses; use of “decision weights” rather than probabilities; and asymmetry between losses and gains, with people weighting losses more heavily. All three effects impact on a person’s risk tolerance (i.e., how risk averse or risk seeking they are). We present four studies highlighting the impact of Prospect Theory on decision value and, particularly, changes in decision value resulting from differences between individual and company risk tolerances. Study one shows losses resulting from risk aversion due to diminishing returns, discussing and comparing individual and corporate risk tolerances; the second highlights the impact of using decision weights; and the third the effect of loss/gain asymmetry. The fourth study is not directly based on Prospect Theory but rather shows the effect of the chance of ruin [6] on risk tolerance. Results indicate that the Prospect Theory effects cause changes in risk tolerance resulting in lost value compared to risk neutral decisions and that this is strongest when the probability of success is low. Any difference between individual and corporate risk tolerances also impacts on value. The results of the fourth study, conversely, show why it can benefit an individual or (less often) a company to be risk averse, as this is demonstrated to reduce the chance of ruin and thus can increase EV in the long run. Finally, we discuss the implications of these findings for corporate and individual decision makers, arguing that the corporate risk tolerances observed by Walls [1, 2] are, in fact, aggregated individual risk tolerances which should be compared to ideal corporate risk tolerances calculated using the chance of ruin for a company with a particular portfolio of investments.