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Risk Aversion, Wealth and Background Risk

  • Luigi Guiso
  • Monica Paiella

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We use household survey data to construct a direct measure of absolute risk aversion based on the maximum price a consumer is willing to pay to buy a risky security. We relate this measure to consumers' endowment and attributes and to measures of background risk and liquidity constraints. We find that risk aversion is a decreasing function of endowment - thus rejecting CARA preferences - but the elasticity to consumption is far below the unitary value predicted by the CRRA utility. We also find that households' attributes are of little help in predicting their degree of risk aversion, which is characterized by massive unexplained heterogeneity. However, the consumers' environment affects risk aversion. Individuals who are more likely to face income uncertainty or to become liquidity constrained exhibit a higher degree of absolute risk aversion, consistent with recent theories of attitudes towards risk in the presence of uninsurable risks.

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Paper provided by Bank of Italy, Economic Research and International Relations Area in its series Temi di discussione (Economic working papers) with number 483.

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Date of creation: Sep 2003
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Handle: RePEc:bdi:wptemi:td_483_03
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  1. Guiso, Luigi & Jappelli, Tullio, 2000. "Household Portfolios in Italy," CEPR Discussion Papers 2549, C.E.P.R. Discussion Papers.
  2. Luigi Guiso & Paola Sapienza & Luigi Zingales, 2000. "The Role of Social Capital in Financial Development," NBER Working Papers 7563, National Bureau of Economic Research, Inc.
  3. Luigi Guiso & Monica Paiella, 2005. "The Role Of Risk Aversion In Predicting Individual Behavior," Temi di discussione (Economic working papers) 546, Bank of Italy, Economic Research and International Relations Area.
  4. Torrini, Roberto, 2005. "Cross-country differences in self-employment rates: the role of institutions," Labour Economics, Elsevier, vol. 12(5), pages 661-683, October.
  5. Guiso, Luigi & Jappelli, Tullio, 1996. "Background Uncertainty and the Demand for Insurance Against Insurable Risks," CEPR Discussion Papers 1423, C.E.P.R. Discussion Papers.
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  7. Luigi Guiso & Tullio Jappelli, 2007. "Information Acquisition and Portfolio Performance," Economics Working Papers ECO2007/45, European University Institute.
  8. Matthew Rabin, 2001. "Risk Aversion and Expected-Utility Theory: A Calibration Theorem," Method and Hist of Econ Thought 0012001, EconWPA.
  9. Guiso, Luigi & Paiella, Monica, 2001. "Risk Aversion, Wealth and Background Risk," CEPR Discussion Papers 2728, C.E.P.R. Discussion Papers.
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  12. Guiso, Luigi & Jappelli, Tullio & Terlizzese, Daniele, 1994. "Income Risk, Borrowing Constraints and Portfolio Choice," CEPR Discussion Papers 888, C.E.P.R. Discussion Papers.
  13. Gollier, Christian, 2001. "Wealth Inequality and Asset Pricing," Review of Economic Studies, Wiley Blackwell, vol. 68(1), pages 181-203, January.
  14. Shane Frederick, 2005. "Cognitive Reflection and Decision Making," Journal of Economic Perspectives, American Economic Association, vol. 19(4), pages 25-42, Fall.
  15. Charles A. Holt & Susan K. Laury, 2002. "Risk Aversion and Incentive Effects," American Economic Review, American Economic Association, vol. 92(5), pages 1644-1655, December.
  16. Hennessy, David A. & Lapan, Harvey E., 2006. "On the nature of certainty equivalent functionals," Journal of Mathematical Economics, Elsevier, vol. 43(1), pages 1-10, December.
  17. Christopher D. Carroll & Miles S. Kimball, 1995. "On the concavity of the consumption function," Finance and Economics Discussion Series 95-10, Board of Governors of the Federal Reserve System (U.S.).
  18. Heaton, John & Lucas, Deborah, 2000. "Portfolio Choice in the Presence of Background Risk," Economic Journal, Royal Economic Society, vol. 110(460), pages 1-26, January.
  19. Renate Schubert, 1999. "Financial Decision-Making: Are Women Really More Risk-Averse?," American Economic Review, American Economic Association, vol. 89(2), pages 381-385, May.
  20. Guiso, Luigi & Jappelli, Tullio & Pistaferri, Luigi, 2002. "An Empirical Analysis of Earnings and Employment Risk," Journal of Business & Economic Statistics, American Statistical Association, vol. 20(2), pages 241-53, April.
  21. Christopher D Carroll, 2000. "Portfolios of the Rich," Economics Working Paper Archive 430, The Johns Hopkins University,Department of Economics.
  22. EECKHOUDT, Louis & Christian GOLLIER & Harris SCHLESINGER, 1994. "Changes in Background Risk and Risk Taking Behavior," Working Papers 005, Risk and Insurance Archive.
  23. Tversky, Amos & Kahneman, Daniel, 1992. " Advances in Prospect Theory: Cumulative Representation of Uncertainty," Journal of Risk and Uncertainty, Springer, vol. 5(4), pages 297-323, October.
  24. James J. Heckman, 1976. "The Common Structure of Statistical Models of Truncation, Sample Selection and Limited Dependent Variables and a Simple Estimator for Such Models," NBER Chapters, in: Annals of Economic and Social Measurement, Volume 5, number 4, pages 475-492 National Bureau of Economic Research, Inc.
  25. John Heaton & Deborah Lucas, 2000. "Portfolio Choice and Asset Prices: The Importance of Entrepreneurial Risk," Journal of Finance, American Finance Association, vol. 55(3), pages 1163-1198, 06.
  26. Kihlstrom, Richard E & Romer, David & Williams, Steve, 1981. "Risk Aversion with Random Initial Wealth," Econometrica, Econometric Society, vol. 49(4), pages 911-20, June.
  27. Daniel J. Benjamin & Sebastian A. Brown & Jesse M. Shapiro, 2006. "Who is “Behavioral”? Cognitive Ability and Anomalous Preferences," Levine's Working Paper Archive 122247000000001334, David K. Levine.
  28. Kimball, Miles S, 1993. "Standard Risk Aversion," Econometrica, Econometric Society, vol. 61(3), pages 589-611, May.
  29. Christian Gollier & Richard J. Zeckhauser, 1997. "Horizon Length and Portfolio Risk," NBER Technical Working Papers 0216, National Bureau of Economic Research, Inc.
  30. Pratt, John W & Zeckhauser, Richard J, 1987. "Proper Risk Aversion," Econometrica, Econometric Society, vol. 55(1), pages 143-54, January.
  31. Joël Peress, 2004. "Wealth, Information Acquisition, and Portfolio Choice," Review of Financial Studies, Society for Financial Studies, vol. 17(3), pages 879-914.
  32. Barsky, Robert B, et al, 1997. "Preference Parameters and Behavioral Heterogeneity: An Experimental Approach in the Health and Retirement Study," The Quarterly Journal of Economics, MIT Press, vol. 112(2), pages 537-79, May.
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