Behavioral Models of Risk Taking in Business Decisions: A Survey and Evaluation

Abstract

Many business decisions involve comparative evaluation of alternatives that can be described by probability distributions over future returns. Examples include long-term contract evaluation, production planning, employee selection, capital budgeting, quality control, and audit planning. Numerous normative models for comparing probability distributions over future returns have been proposed for such situations. The model most often cited in the literature is the mean-variance model. It is based on three preference assumptions (Sharpe [1970]). (1) The value of an investment can be completely described by its expected return (,u) and standard deviation (a-). (2) u is good: other things being equal, more is preferred to less. (3) ais bad: other things being equal, less is preferred to more. While the applicability of this and other normative models to aggregate market behavior has been studied extensively, the degree to which these models describe individual managers' actual risk preferences has received little attention in the business literature, even though the individual level of analysis is relevant to many decisions made within the firm. This paper will evaluate alternative descriptive