Approximating Risk Aversion in Decision Analysis Applications

• Published in: Decision analysis 2004-03, Vol.1 (1), p.51-67
• Main Author: Kirkwood, Craig W
• Format: Article
• Language: English
• Subjects: Analysis; decision analysis, risk: approximating risk aversion; Decision-making; Risk assessment; Utility theory; utility/preferences, estimation: approximating utility functions; utility/preferences, theory: accuracy of utility function approximations
• ISSN: 1545-8490; 1545-8504
• DOI: 10.1287/deca.1030.0007

This paper investigates the impact of risk aversion in decision analyses under uncertainty with a single evaluation measure and presents a simple procedure for approximately addressing risk aversion in a way that is defensible for many decisions. Specifically, a simulation study is presented that leads to guidelines for determining when an expected utility analysis should be conducted for a decision, rather than simply an expected value analysis, and what form of utility function should be used for this expected utility analysis. The simulation study shows that a sensitivity analysis using an exponential utility function should be conducted for most decision analyses, but that this sensitivity analysis can often establish, without requiring utility information from the decision maker , that no further utility analysis is required. In addition, when further utility analysis is required, the simulation study shows that this can be done in a simple way using an exponential utility function that will be accurate for many decision analyses. However, in situations where there is equal or greater downside risk than upside potential, a more detailed study of the decision maker's utility function may be necessary.