Risk Aversion

Risk aversion is related to investor behavior. Some investors are more comfortable with uncertainty in the outcome than others and are prepared to tolerate more risk in the pursuit of greater portfolio returns.

Risk Seeking

Risk seekers actively pursue risk even when the potential outcome does not justify taking extra risk. This is a gambling instinct: choosing to place money at casinos, knowing the odds of winning are slim or that the expected return is actually negative.

Risk Neutrality

If an investor is indifferent to the outcome, they may be risk-neutral. This means they will likely pursue higher returns even if this comes with higher risk. This is often the case, particularly when the investment represents a small portion of their wealth or portfolio.

Risk Aversion

A risk-averse investor will gravitate towards a guaranteed outcome and shy away from risky investments. A lower, certain return will be preferable to a higher, less certain return. Market data typically represents risk-averse behavior on the part of investors, and risk aversion is, as such, a standard assumption.

Risk Tolerance

Risk tolerance refers to the amount of risk an investor is willing to take in order to achieve their investment goals and objectives. A higher risk tolerance shows a greater willingness to take risks. This implies that risk tolerance and risk aversion are negatively correlated.

Question

In a choice of a certain $45 versus a 50% chance of $100, an investor chooses the certain $45. What type of risk behavior does the following scenario represent?

A. Risk-seeking behavior.

B. Risk-neutral behavior.

C. Risk-averse behavior.

Solution

The correct answer is C.

A risk-averse investor will likely select the guaranteed option instead of the uncertain outcome, even though the uncertain outcome has a higher expected return of $50.