MBA students are taught to use the expected monetary value (EV) to evaluate risky opportunities. The reaction of individuals to risk, however, is far more complex. In fact, individuals are rarely found to be consistently risk neutral, risk averse, or risk seeking. They can be all these things, depending on whether the probabilities are small or large or the outcomes are gains or losses. The purpose of this note is to introduce a behavioral model that modifies EV and does a better job of predicting the perceived value of a risk profile. The model builds on the distinction between probabilities and decision weights, as well as the notions of framing and loss aversion, as put forward by prospect theory.
Supplements to the note include a video and an Excel spreadsheet to aid student understanding.