Aversion

What is Risk Aversion?

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• published: 09 Apr 2015
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Welcome to the Investors Trading Academy talking glossary of financial terms and events. Our word of the day is “Risk Aversion”. Risk aversion is a concept in economics and finance, based on the behavior of humans -especially consumers and investors while exposed to uncertainty to attempt to reduce that uncertainty. Risk aversion is the reluctance of a person to accept a bargain with an uncertain payoff rather than another bargain with more certain, but possibly lower, expected payoff. For example, a risk-averse investor might choose to put his or her money into a bank account with a low but guaranteed interest rate, rather than into a stock that may have high expected returns, but also involves a chance of losing value. The subjective tendency of investors to avoid unnecessary risk. It is subjective because different investors have different definitions of unnecessary. An investor seeking a large return is likely to see more risk as necessary, while one who only wants a small return would find such an investment strategy reckless. However, most rational economic actors are sufficiently risk averse such that, given two investments with the same return and different levels of risk; they would choose the less risky investment. A person is given the choice between two scenarios, one with a guaranteed payoff and one without. In the guaranteed scenario, the person receives $50. In the uncertain scenario, a coin is flipped to decide whether the person receives $100 or nothing. The expected payoff for both scenarios is $50, meaning that an individual who was insensitive to risk would not care whether they took the guaranteed payment or the gamble. However, individuals may have different risk attitudes. By Barry Norman, Investors Trading Academy