Risk aversion

Risk aversion is a concept central to financial theory. Many valuation models, including CAPM, assume that higher risk investments need to be priced to generate higher returns.

A risk averse investor prefers certainty to risk, and low risk to high risk. Consider two investments, one of which will definitely return £100, the other of which has a 50% chance of returning £200 and a 50% chance of returning nothing. Both have an expected return of £100.

  • A risk averse investor would prefer the certain £100.
  • A risk neutral investor would not have any preference.
  • A risk seeking investor would prefer the chance of getting the £200.

Whether people actually are risk averse is an interesting question. Investors do seem to act fairly consistently in a risk averse manner. However, there are plenty of examples of people exhibiting risk seeking behaviour - gambling for example.

Investor attitudes to risk and what determines it is one of many questions that are considered by behavioural finance.

Copyright © 2005-2016