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Risk Aversion, Wealth, and Background Risk

  • Luigi Guiso
  • Monica Paiella

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 for a risky security. We relate this measure to consumers' endowments and attributes and to measures of background risk and liquidity constraints. We find that risk aversion is a decreasing function of the endowment. thus rejecting CARA preferences. We estimate the elasticity of risk aversion to consumption at about 0.7, below the unitary value predicted by 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. We show that the consumer's 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 toward risk in the presence of uninsurable risks.

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Paper provided by European University Institute in its series Economics Working Papers with number ECO2007/47.

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Date of creation: 2007
Date of revision:
Handle: RePEc:eui:euiwps:eco2007/47
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  1. Luigi Guiso & Tullio Jappelli, 1998. "Background Uuncertainty and the Demand for Insurance against Insurable Risks," CSEF Working Papers 02, Centre for Studies in Economics and Finance (CSEF), University of Naples, Italy.
  2. Cascio, Elizabeth U. & Lewis, Ethan Gatewood, 2005. "Schooling and the AFQT: Evidence from School Entry Laws," IZA Discussion Papers 1481, Institute for the Study of Labor (IZA).
  3. Luigi Guiso & Monica Paiella, 2008. "Risk Aversion, Wealth, and Background Risk," Journal of the European Economic Association, MIT Press, vol. 6(6), pages 1109-1150, December.
  4. Daniel J. Benjamin & Sebastian A. Brown & Jesse M. Shapiro, 2013. "Who Is ‘Behavioral’? Cognitive Ability And Anomalous Preferences," Journal of the European Economic Association, European Economic Association, vol. 11(6), pages 1231-1255, December.
  5. 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.
  6. Christopher D. Carroll & Miles S. Kimball, 1995. "On the Concavity of the Consumption Function," Macroeconomics 9503003, EconWPA.
  7. Philippe Weil, 1992. "Equilibrium Asset Prices With Undiversifiable Labor Income Risk," NBER Working Papers 3975, National Bureau of Economic Research, Inc.
  8. Pratt, John W & Zeckhauser, Richard J, 1987. "Proper Risk Aversion," Econometrica, Econometric Society, vol. 55(1), pages 143-54, January.
  9. Luigi Guiso & Paola Sapienza & Luigi Zingales, 2004. "The Role of Social Capital in Financial Development," American Economic Review, American Economic Association, vol. 94(3), pages 526-556, June.
  10. 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.
  11. Kihlstrom, Richard E & Romer, David & Williams, Steve, 1981. "Risk Aversion with Random Initial Wealth," Econometrica, Econometric Society, vol. 49(4), pages 911-20, June.
  12. Gollier, Christian & Zeckhauser, Richard J, 2002. " Horizon Length and Portfolio Risk," Journal of Risk and Uncertainty, Springer, vol. 24(3), pages 195-212, May.
  13. Guiso, Luigi & Paiella, Monica, 2004. "The Role of Risk Aversion in Predicting Individual Behaviours," CEPR Discussion Papers 4591, C.E.P.R. Discussion Papers.
  14. Luigi Guiso & Tullio Jappelli, 2000. "Household Portfolios in Italy," CSEF Working Papers 43, Centre for Studies in Economics and Finance (CSEF), University of Naples, Italy.
  15. Guiso, Luigi & Jappelli, Tullio & Terlizzese, Daniele, 1996. "Income Risk, Borrowing Constraints, and Portfolio Choice," American Economic Review, American Economic Association, vol. 86(1), pages 158-72, March.
  16. Kimball, Miles S, 1993. "Standard Risk Aversion," Econometrica, Econometric Society, vol. 61(3), pages 589-611, May.
  17. Torrini, Roberto, 2005. "Cross-country differences in self-employment rates: the role of institutions," Labour Economics, Elsevier, vol. 12(5), pages 661-683, October.
  18. Shane Frederick, 2005. "Cognitive Reflection and Decision Making," Journal of Economic Perspectives, American Economic Association, vol. 19(4), pages 25-42, Fall.
  19. 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.
  20. 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.
  21. Matthew Rabin., 2000. "Risk Aversion and Expected-Utility Theory: A Calibration Theorem," Economics Working Papers E00-279, University of California at Berkeley.
  22. 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.
  23. Joël Peress, 2004. "Wealth, Information Acquisition, and Portfolio Choice," Review of Financial Studies, Society for Financial Studies, vol. 17(3), pages 879-914.
  24. Eeckhoudt, Louis & Gollier, Christian & Schlesinger, Harris, 1996. "Changes in Background Risk and Risk-Taking Behavior," Econometrica, Econometric Society, vol. 64(3), pages 683-89, May.
  25. Gollier, C., 1997. "Wealth Inequality and Asset Pricing," Papers 97.486, Toulouse - GREMAQ.
  26. Christopher D Carroll, 2000. "Portfolios of the Rich," Economics Working Paper Archive 430, The Johns Hopkins University,Department of Economics.
  27. 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.
  28. Breeden, Douglas T., 1979. "An intertemporal asset pricing model with stochastic consumption and investment opportunities," Journal of Financial Economics, Elsevier, vol. 7(3), pages 265-296, September.
  29. repec:tpr:qjecon:v:112:y:1997:i:2:p:537-79 is not listed on IDEAS
  30. 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.
  31. Guiso, Luigi & Jappelli, Tullio, 2006. "Information Acquisition and Portfolio Performance," CEPR Discussion Papers 5901, C.E.P.R. Discussion Papers.
  32. 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.
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