6. Risk Aversion

If only because protective instincts are pervasive among humans and prized in many social settings,¹ behavioral finance demands a credible account of risk aversion.² That account begins with the decline of expected utility theory.³ Behavioral economics arose as a response to the limitations of conventional game theory and expected utility theory.⁴ Behavioral economics adds a host of considerations that elude these conventional models of utility and risk.⁵ Because conventional definitions of risk aversion hold the key to solving behavioral challenges such as the equity risk premium and the equity premium puzzle,⁶ I will now propound some of the foundations of expected utility theory. I start by presenting the absolute and relative versions of the Arrow–Pratt measures of risk aversion, named for Kenneth Arrow⁷ and John Pratt.⁸ These measures are also known as the coefficients of absolute and relative risk aversion.⁹