What is a realistic aversion to risk for real - world individual investors ? ∗

Most frequently used class of utility functions for modelling the investment policy of individual agents by the constant relative risk aversion (CRRA) utility functions. The objective of this paper is to try to provide the plausible risk aversion parameter of individual households under this assumption. I argue that the risk aversion of an individual investor may be significantly larger than is usually being considered plausible in economic literature. Specifically, I argue that, for the purposes of mediocre risk taking, an average investor’s risk aversion parameter is in order of p = 30. Few investors, usually with enough experience, exhibit aversion to risk below p = 20, while many individuals with little risk-taking experience and distaste for risk endeavors may exhibit p > 300. I present empirical evidence for these statements. The risk aversion coefficients suggested in this paper are an outcome of a partial equilibrium model, analyzing the behavior of real-world individuals. Additionally, we are able to address other issues in financial economics. Namely, the assumption of higher risk aversion resolves the equity premium puzzle. It is possible to obtain the low participation in stock market even with small transaction costs, assuming high risk aversion for some agents. We can also conclude that the risk free rate is not too low for sufficiently high risk aversion.