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Risk Aversion

Risk Aversion

Risk aversion is related to investor behavior. Some investors are more comfortable with an 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 Neutrallity

If an investor is indifferent to the outcome, then they may be risk-neutral. This means they will likely pursue higher returns even if this comes along with higher risk. This will often be the case particularly when the investment represents a small portion of their overall 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 seen as 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 risk. This implies that risk tolerance and risk aversion are negatively correlated.

Question

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

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 although the uncertain outcome has a higher expected return of $50.

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