Individual vs. Aggregate Preferences: The Case of a Small Fish in a Big Pond

Abstract:     
We show that there can be significant difference between risk preferences of individual investors and aggregate preferences toward risk in the economy. To demonstrate this, we investigate aggregate properties of an economy where all investors have convex utility functions corresponding to risk seeking behavior. In the case of risk seeking individual agents with identical initial endowments, assuming a budget constraint, and facing perfect competition the aggregate economy is risk neutral. In the case of risk seeking individuals with different initial endowments, we show that if there exists a continuum of wealth classes the economy in the aggregate will exhibit risk averse behavior. Thus, an economy consisting of risk seeking agents can lead to an aggregate economy that is risk averse. We prove that the converse is also true. For an economy that in the aggregate exhibits risk aversion we can construct an economy of all risk seeking agents that in the aggregate produces the given risk averse indifference curve. That is, an economy demanding a risk premium can be formed from individuals who do not demand such compensation. In the context of the equity premium puzzle our analysis shows that for an aggregate economy to display a high degree of risk aversion and to demand a relatively high risk premium individuals do not need to have implausibly high risk aversion.

Number of Pages in PDF File: 44

Keywords: Risk aversion, risk seeking, investor sentiment, risk premium

JEL Classification: G10, D11, D80

working papers series