Multi-objective Decision Analysis

Determining the Risk Tolerance

The risk tolerance determines the curvature of the exponential utility function. When the risk tolerance is positive, the utility function is concave, or “hill-like.” Risk-averse decision makers have positive risk tolerances. Conversely, when the risk tolerance is negative, the utility function is convex, or “bowl-like.” Risk-seeking decision makers have negative risk tolerances. Finally, when the risk tolerance is infinity, the utility function is a straight line. Risk-neutral decision makers have straight-line utility functions.9

To determine a decision maker’s risk tolerance, it is important to utilize the concept of the certainty equivalent for an alternative with uncertain outcomes. The certainty equivalent ...