We, humans, have a general tendency to avoid taking risks when we can, a notion that we refer to as risk aversion. This has the important implication that when we are faced with a choice between a safe payoff and a risky one, we’d opt for the latter only if it entails a sufficient risk premium, which is our compensation (or reward) for bearing risk.
However, do we always act in a risk-averse manner? And if not, what is the opposite of risk averse? Theoretically, we can come up with three broad types of risk attitude:
- Risk averse
- Risk neutral
- Risk seeking
So, we can think of risk seeking as the opposite of risk averse. Risk-seeking behavior entails a yearning for risk even if it may result in an inferior outcome than a safer choice in expectation. In the rest of this lesson, we further elaborate on how exactly we differentiate risk-seeking individuals from risk-averse ones.
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Risk-averse vs risk-seeking behavior
In the previous lesson, we introduced the concept of a fair game. A fair game is typically risky, but playing such a game would result in neither a loss nor a profit in expectation.
Intuitively, risk-averse individuals would not like such games because they involve risk without any reward. Therefore, they would refuse to play them. In contrast, risk-seeking people would happily accept fair games as they crave risk exposure, and such games provide that without an expected loss.
Note that this doesn’t mean that risk-seeking individuals would just take any risk. They would, of course, reject risky prepositions that entail a high degree of expected losses. And, a person’s risk appetite can vary across circumstances and over time.
Finally, and for the sake of completeness, a risk-neutral individual would be indifferent to a fair game.
summary
In financial economics, there are three broad categories of risk attitudes. First, we have risk aversion. This can be thought of as a general dislike for risk. Then, we have risk seeking, which is a desire for bearing risk. Risk seeking is the opposite of risk averse. Finally, we have risk-neutral behavior, which is characterized by indifference toward risk.
Further reading:
Zaleskiewicz (2001), “Beyond risk seeking and risk aversion: personality and the dual nature of economic risk taking“, European Journal of Personality, Vol. 1(S1), pp. S105-S122.
what is next?
This lesson is part of our free course on investments.
- Next lesson: We define the risk aversion coefficient, differentiating between absolute risk aversion and relative risk aversion.
- Previous lesson: We introduced the concept of a fair game using the coin toss game as an illustrative example.
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