The Allais Paradox and Upside/Downside Risk Preference: An Experimental Analysis With Probability Weighting and Chernoff Faces

ABSTRACT The Allais Paradox is often attributed to the strong attraction of a certain option that avoids a downside risk, i.e., a small chance of a low payoff. In contrast, there is clear evidence from laboratory and field data that people are attracted to the upside risk of obtaining a relatively high payoff. Examples of upside risk include investments in risky tech stocks, participation in rent‐seeking contests, or savings in lottery‐based retirement accounts. The experiment reported in this paper shows a tendency for the same people to exhibit both downside risk aversion and upside risk preference. The analysis uses nonlinear probability weighting to connect the upside/downside risk preference distinction with the standard behavior observed in an Allais paradox. The results are illustrated by Chernoff faces with features that are pulled down by risk aversion and up by risk preference.