, Volume 8, Issue 4, pp 363-374

Neurobiological studies of risk assessment: A comparison of expected utility and mean-variance approaches

Abstract

When modeling valuation under uncertainty, economists generally prefer expected utility because it has an axiomatic foundation, meaning that the resulting choices will satisfy a number of rationality requirements. In expected utility theory, values are computed by multiplying probabilities of each possible state of nature by the payoff in that state and summing the results. The drawback of this approach is that all state probabilities need to be dealt with separately, which becomes extremely cumbersome when it comes to learning. Finance academics and professionals, however, prefer to value risky prospects in terms of a trade-off between expected reward and risk, where the latter is usually measured in terms of reward variance. This mean-variance approach is fast and simple and greatly facilitates learning, but it impedes assigning values to new gambles on the basis of those of known ones. To date, it is unclear whether the human brain computes values in accordance with expected utility theory or with mean-variance analysis. In this article, we discuss the theoretical and empirical arguments that favor one or the other theory. We also propose a new experimental paradigm that could determine whether the human brain follows the expected utility or the mean-variance approach. Behavioral results of implementation of the paradigm are discussed.