How do investors differ in terms of their risk preferences? Are we all risk lovers? Or, do we prefer to avoid or minimize risk if we can? Perhaps our risk appetite is more dynamic. For instance, it may depend on the situation and our circumstances. In this post, we will elaborate on how financial economists categorize risk preferences. We will discuss why this is relevant for investment decisions as well.
- Distinguish between risk-averse, risk-seeking, and risk-neutral behavior.
- Understand the implications of risk preferences for pricing risky assets such as stocks and corporate bonds.
The relation between risk appetite and fair bets
Imagine a simple bet between two players (A, B) involving the toss of a fair coin (i.e., 50% probability of heads, 50% probability of tails). If the coin lands heads, player A gives $10 to player B. If it lands tails, player B gives $10 to player A.
Imagine that this bet is played many times. Then, each player is expected to win it half of the time. So, the players would neither gain nor lose. We call such bets where the expected gain (or loss) is zero as fair bets. Would you accept, reject, or be indifferent about such a bet?
Financial economists define the act of rejecting a fair bet, which offers neither gain nor loss but pure risk, as risk-averse behavior. If you accepted it, you would be exhibiting risk-seeking behavior. If you were indifferent about taking or refusing such a bet, and thus indifferent about pure risk, you would be demonstrating risk-neutral behavior. In general, financial economists refer to investors who tend to refuse fair bets as risk-averse investors. Those who tend to accept fair bets are considered to be risk-seeking investors. And, those who are generally indifferent about fair bets are risk-neutral investors.
Dynamic nature of our risk preferences
According to financial economists, investors are risk averse to varying degrees under many (but not all) circumstances. Risk-averse investors would refuse fair bets and accept risky bets only if the expected gain is sufficiently positive. In other words, they dislike risk and seek a reward in return for bearing it. This has important implications for asset pricing. It leads to the concept of risk premium, which we discuss in the next post.
Can we be risk averse under some circumstances and risk seeking under others? After all, many people engage in gambling and/or sports betting which involve bets where the expected gain is negative (i.e., there is an expectation of a loss) as the casino or the betting company gets its cut (remember, the house always wins!). Indeed, there is evidence that our risk appetite depends on various factors (e.g., gender) and the circumstances we face. For example, the well-established prospect theory developed by Daniel Kahneman and Amos Tversky is built on the evidence that we tend to exhibit risk-seeking behavior if it helps us avoid realizing a loss, whereas risk-averse behavior is observed when faced with a risky bet involving gains only.
In summary, individuals differ in terms of their appetite for risk. While we tend to dislike risk to varying degrees under many circumstances, there may be instances where we develop an appetite for risk. An important implication of risk aversion is that we would only bear risk if that comes with a sufficient reward in the form of a risk premium.
What is next?
Thank you for reading this post, which is part of our free course on investments. The previous post in the series introduced the concept of the risk-free rate of return. In the next post, we will explain the meaning of the “risk aversion coefficient” and offer formulas for Arrow-Pratt measures of risk aversion.
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