Risk aversion is related to investor behavior. Some investors are more comfortable than others with an uncertainty in the outcome and are prepared to tolerate more risk in the pursuit of greater portfolio returns.
Risk seekers actively pursue risk even when the potential outcome does not justify taking on the 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.
If an investor is indifferent about the outcome then they may be risk neutral. This means they will likely pursue higher returns even if this is accompanied by higher risk and particularly so when the investment represents a small portion of their overall wealth or portfolio.
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 a standard assumption.
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 implying risk tolerance and risk aversion are negatively correlated.
What type of risk behavior does the following scenario represent: In a choice of a certain $45 versus a 50% chance of $100, the investor chooses the certain $45.
A. Risk-seeking behavior
B. Risk-neutral behavior
C. Risk-averse behavior
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 the higher expected return of $50.
Reading 41 LOS 41d:
Explain risk aversion and its implications for portfolio selection