Risk, and how to manage it, are the centrepieces of investing. However, the conventional academic approach to it is flawed – and so too is our everyday thinking about it.
Typically, academic economists have tried to measure attitudes to risk by a single number, called the coefficient of relative risk aversion. This derives from a simple idea – that each additional pound gives us less satisfaction (utility) so we therefore reject some bets which have a positive expected pay-off because the amount we would win would please us less than a loss of similar magnitude would displease us.
This, however, quickly runs into problems. One is that it doesn’t explain why millions of us buy insurance and at the same time buy risky assets, gamble or play dangerous sports. Another was pointed out by Matthew Rabin and Richard Thaler in 2001. They show that this approach implies that if we reject gambles with small potential wins then we should also reject ones with bigger possible wins, because we discount extra wealth so much – which doesn’t make sense.